2025 Market Outlook

January 1, 2025

Despite Headwinds, Higher Earnings Could Extend Stock Gains

Let me start with a mea culpa… In this space last year, I wrote: "While market history is replete with examples of significant market declines followed by multi-year recoveries and bull markets (just as we’ve just had), there are no examples of the S&P 500 returning 25% followed by another annual gain of nearly the same magnitude. Bottom line: temper your expectations."

While we did temper our expectations, our five equity model portfolios stayed true to their respective missions and long-term objectives by not market-timing (staying fully invested), managing risk, and investing in well-managed stock funds. As a result, they largely kept pace with the S&P 500’s 25.0% return.

That they fared as well as they did without undo risk was another plus. (Lest we forget, the Nasdaq Composite is about 25% more volatile - riskier - than the S&P 500!)

2024 was unexceptional in that every year provides plenty of surprises. But it was exceptional for stocks in that it was the first time since the 1990s to score outsized back-to-back annual gains. And it was an historic first return-wise because corporate earnings growth exceeded expectations. In that regard, the Magnificent Seven remained largely magnificent!

While inflation and unemployment didn’t fully match the Fed’s idealized levels, the country’s central bankers reckoned the economy had cooled enough to warrant three rate-cuts. Silencing naysayers, Chairman Powell executed a soft landing (no recession). In fact, GDP accelerated in the third quarter to an annualized rate of 3.1% — its fastest pace of 2024.

There’s also the matter of valuations. If you recall 1998 to early 2000, tech valuations were sky-high, until they weren't. The dot.com bust took the Nasdaq Composite from a peak of just over 5,000 in March 2000 to 1,100 by October 2002. In retrospect, the Nasdaq’s collapse shouldn’t have surprised anyone as its P/E (price-to-earnings) surpassed 70! Today, it’s an elevated 46, up roughly a third from a year ago. As for the S&P 500, its P/E of 29 is about 13% higher from last year, though much of that is also driven by the Magnificent Seven.

While concerning, companies with new technologies and disruptive business models behind them often sustain high valuations. So while this is a cautionary tale about having too much large-cap growth fund exposure, it is not an argument for abandoning stocks.

Downside Risks
Several things concern me.

While the second Trump Administration appears genuinely resolved to downsize government and cut spending, the first fight over the debt ceiling comes within weeks of the next president’s swearing-in.

For whatever one thinks about government shutdowns, the stakes have never been bigger (because deficits have never been larger) and financial markets may no longer view the matter with indifference.

Inflation is another worry, and that ties directly to the former matter. Deficit spending in excess of $2 trillion annually forces money into the economy. In the short term, markets love the increased demand for goods and services. But eventually, prices rise.

While that’s an addressable problem, this one’s tougher: An indirect contributor to inflation is the $75 trillion in accumulated wealth that 65 million baby boomers are slowly transferring to their children. At the very least, the “Great Wealth Transfer” is contributing to higher home prices as parents and even grandparents provide financial assistance to Millennials who are both house and cash poor.

Tariffs and trade barriers are also inflationary. But if used, I hope they’re deployed judiciously and mostly for national security.

The bottom line is that late in 2024, inflation started to tick higher, and the Fed’s rate setting committee is already reconsidering the pace and dept of future cuts. In other words, if the dot plot on page 3 is optimistic, there would be downward pressure on stocks (especially small- and mid-caps) as well as bonds.

My greater concerns, however, are interconnected: productivity, the promise of AI, and earnings growth.

As noted throughout this issue, the Magnificent Seven have disproportionately lifted stock indexes in both 2023 and 2024. While I know AI’s promise is great, NVIDIA and others must start delivering what investors want most: earnings that not only justify the valuations of a handful of AI stocks, but of the broader market, too. Indeed, small hiccups in sales and earnings may be amplified across the broader market.

Notwithstanding those concerns, the long-term trend for U.S. stocks has always been up. So, as stated in the outset, trying to market-time (even when feeling uneasy about valuations, earnings, inflation, recession and political uncertainty), typically leads to regret.

Indeed, the past 50 years or so have seen 10 recessions and, by my count, a half-dozen bear markets. (The two often coincide.) Yet if you invested just $100 in the S&P 500 in 1975 you’d have nearly $32,000 today. With that in mind, even as bitcoin topped $100,000 last year, I suspect than my brand-new grandson won’t see its value reach $32,000,000 in 2050 (there’s a higher chance of it going to zero!).

I’ve digressed a bit, but I hope I’ve made my point. Keep your long-term money (10-plus years) in the stocks of tangible businesses and, as best you can, tune out the “noise.” As the saying goes, time in the market beats timing the market.

— John Bonnanzio