The Big Picture
With 2024 winding down, it is fair to say that the stock market is looking forward to 2025 for a variety of reasons. One of those reasons is the stock market's outstanding performance in 2024, which happened in spite of continuing geopolitical conflict, a rancorous election season in the U.S., a faltering Chinese economy, stagnant growth in Europe, and rising -- yes, rising -- interest rates.
The higher market rates reflected festering angst about sticky inflation and an untenable deficit situation but, to be fair, they also reflected the reality that growth in the United States was stronger than expected despite the Fed's tightening campaign.
A fear of recession was swept away by the economic data, the earnings results, and the Fed signaling a pivot to removing policy restraint as inflation trended toward its 2.0% target. The fear of recession was ultimately supplanted by optimism that the U.S. economy will enjoy a soft landing or no landing at all.
That optimism took a good showing by the stock market that had been underpinned by the outperformance of the mega-cap stocks and turned it into a great showing that was driven by broad-based participation across the market-cap spectrum and optimism about the year ahead in the wake of an election that saw Donald Trump emerge victorious in the presidential race and Republicans secure a fairly tight majority position in the House and Senate.
Looking at 2025, then, the stock market is banking on a lot of good things coming to pass: reduced regulations, the extension of the 2017 tax cuts, a further reduction in the Fed's policy rate, double-digit earnings growth, and, if the cohort of market pundits has it right, a roughly 10% gain for the S&P 500.
Criticism and Credit
There is optimism in the air.
Much of it is related to President-elect Trump's political agenda, yet it is also grounded in the Fed's seeming success in keeping the economy on a growth setting. Notwithstanding 11 rate hikes by the Fed between March 2022 and July 2023, real GDP growth has averaged 2.9% since the third quarter of 2022.
Since the first rate hike, the PCE inflation rate has fallen from 7.0% to 2.3% and the core-PCE inflation rate has dropped from 5.6% to 2.8%. The unemployment rate, meanwhile, is still a relatively low 4.2% and initial jobless claims -- a leading indicator -- continue to run well below recession-like levels.
The Fed deservedly received criticism for keeping rates too low for too long, which helped fan the inflation flames, but it now deserves some credit for managing the disinflation. Its job is not complete, however, and it is fair to say that other parts of President-elect Trump's political agenda, which include tariffs and the deportation of illegal immigrants, could reignite inflation pressures.
That risk is also in the air in the Treasury market, which has traded spastically since the election, faltering at first on deficit concerns, rallying back on the news of Scott Bessent being nominated for Treasury Secretary, and sliding again on November CPI and PPI reports that didn't show any improvement in inflation on a year-over-year basis.
The 2-yr note yield, at 4.24%, is down one basis point for the year, but the 10-yr note yield, at 4.40%, is up 52 basis points for the year.
A continued rise in interest rates that sends the 10-yr note yield above 4.50% and on a path toward 5.00% would suck some of the optimism out of the air and limit return prospects for a market entering 2025 with a rich valuation.
A High Starting Point
At 22.4 x forward twelve-month earnings, the market cap-weighted S&P 500 is trading at a 24% premium to its 10-year average, according to FactSet data. That objective reality is why many pundits are pointing the equal-weighted S&P 500 as a better investment vehicle when considering the year ahead. It trades at 17.3x forward twelve-month earnings, which is only a slight premium to its 10-year average.
That is a fair judgment. The upside is that you are not giving up exposure to the mega-cap stocks. The downside is that you are risking underperformance if the mega-cap stocks continue their outperformance.
The bigger message is that one starts from a high(er) valuation point with both the market cap-weighted S&P 500 and equal-weighted S&P 500, because a lot of good news has been priced in already.
Objectively, that should curtail return prospects, but it doesn't preclude another year of robust returns knowing that AI enthusiasm remains in the air, that the incoming administration has an unapologetic pro-growth disposition, and that the cohort of mega-cap stocks has yet to upset investor sentiment with any acute reservations about growth prospects.
Important to Stay on Track
All the good things the market thinks will happen in 2025 must now come to fruition. Why? Because they are baked into stock prices already.
Importantly, there can't be anything that upsets that fundamental view. Why? Because the stock market hasn't really allowed itself to think bad things will happen. It is looking at 2025 with a glass-is-half full mentality, and it expects the glass to be full by the end of the year.
Should something happen that derails the earnings growth outlook, there will be a meaningful correction. The stock market can continue to sport higher valuations, however, if things stay on track.
That is why things like interest rates, the inflation path, the Fed's monetary policy, the deficit, and earnings estimates are going to be watched so closely. There is plenty of room for optimism on all fronts, there just isn't much room for error.
There is a consensus view that 2025 will be another year of positive returns for the stock market. That stands to reason if interest rates remain well behaved and companies deliver on the earnings front, yet it seems to us, given the valuation starting point, that it will require taking on more risk if one wants excess returns.
In that vein, 2025 will require more of an active management style than a passive one. That approach isn't suitable for everyone, which is fine -- and which is why one has to know their risk tolerance.
A passive approach (think indexing) has worked more than fine over the long term, and it is apt to work fine in 2025 if the good things that are expected to happen do happen. In that instance, though, one may find better value opportunities lower on the market-cap spectrum.
The small-cap and mid-cap indices have less demanding valuations relative to their historical averages than their large-cap counterparts do. They will have performance problems, though, if interest rates heat up and/or consumer spending falters.
What It All Means
There was a positive buzz on Wall Street leading up to the election and an unmistakable buzz following the election. The stock market, in a sense, will be playing politics in 2025.
It's more fun and games now with visions of less regulation and friendly tax policy dancing in its head, but the specter of tariff reprisals, geopolitical conflict, deficit angst, and inflation heating up are elements investors should hope to remain under wraps. Playing politics will be less fun for the stock market if they don't.
This market may have gotten ahead of itself pricing in good things, but it won't allow itself to get consumed with the thought of bad things happening. Not now anyway when the political signaling is a tailwind and earnings estimates remain in an uptrend.
The stock market will deal with bad news if it happens, and course correct in a proportional manner. For now, 2025 looks like a year the stock market is ready to embrace with high hopes and higher prices.
