Taking Stock for 2025
2024 was a noteworthy year for the U.S. equity market. On a total return basis, the S&P 500 closed up over 20% and notched over 55 all-time highs throughout the course of the year. With 2024 now in the rearview mirror, focus shifts to 2025 with various factors for investors to consider. While the new U.S. presidential administration, the pace of Federal Reserve rate cuts, and geopolitical conflicts will likely continue to dominate investor mindshare, this is only part of the story. The fundamental, technical, and economic backdrop for the United States presents its own unique set of tailwinds and obstacles for 2025.
Gauging the character of the next market drawdown could provide clues for 2025. Will 2024’s market leaders (the Magnificent Seven) consolidate as leaders, or will their high valuations become an obstacle? Will the defensive sectors such as Consumer Staples and Utilities begin to outperform? Will earnings growth or multiple expansion be the primary driver of returns in 2025?
In this Roundhill Roundup, we take stock of the market’s backdrop as a new year of trading begins and weigh what one of these market drivers may be most impactful in 2025.
Valuations a Risk
The S&P 500 registered a robust 2024 despite investor handwringing on the market’s lofty valuations by most metrics. Up to this point, investors have been comfortable paying the “dream premium” for some of the market’s growthiest corners of the market. As of November 30, 2024, the Case/Shiller cyclically adjusted price to earnings ratio for the S&P 500 is 37.4x. Historically, this level has preceded below average forward returns for the S&P 500 since 1950. While valuation is a poor market timing tool in the short term, lofty valuations tend to hinder forward equity performance in the long run. Investors are rightfully questioning if the bill comes due in 2025.
Healthy Jobs Market = Lower Equity Returns?
Through the lens of economic data, year-over-year inflation has settled under 3% while the U.S. jobs market has softened without sparking recessionary fears. So far, the market has responded positively to this goldilocks economic environment. The question going forward is if there is much of a tailwind for equities remaining. When bucketing the U.S. unemployment rate by deciles since 1950, the current unemployment rate of 4.2% is in decile three. Historically, the S&P 500 has averaged a +8.3% 12-month return following similar readings, implying that it is hard to capture further equity upside in such a stable economic environment of low unemployment. Higher equity market returns can typically follow from higher unemployment rate environments because economic weakness tends to occur near equity market lows. With the unemployment rate near historically low levels and the equity market near all-time highs, the upside catalyst of positive economic surprises from poor data is not present.
Internal Trends Deteriorating But Defensives Lagging
As of year end, 70% of the S&P 500 are trading with a positive year-to-date total return in 2024. Can the momentum persist into 2025? While some softness emerged at the end of the year with less than 60% of the S&P 500 trading above its 200-day moving average (its lowest readings of the year), the market cannot be wholly written off as long as the Magnificent Seven continue to trade well. As a group, the Magnificent Seven contributed over $5.5 trillion to the S&P 500’s over $10 trillion market cap rise in 2024 through December 31 (accounting for 55% of total). For now, the Consumer Staples, Utilities, and Health Care sectors, traditionally viewed as defensive sectors by equity investors, are trading near fresh relative lows versus the S&P 500. In our view, this indicates the recent weakness in equities is more corrective in nature versus the beginning of a prolonged market downturn. Weak patches can happen, but we’d like to see internal participation improve.
Earnings Growth Robust for 2025
With one more quarter of financial results to go, the S&P 500 is currently tracking for ~10% earnings growth for 2024 as investors shift focus to 2025. As of December 13, the S&P 500 is estimated to see earnings grow 14.3% in 2025. While downside revision is possible as 2025 comes into focus, this would be the index’s strongest tally for earnings growth since 2021’s ~50% growth as the world recovered from the covid-19 recession.
At the sector level, Technology is expected to lead the way with ~21% earnings growth, followed closely by Health Care (~20%) and Industrials (~19%). The slowest growing sectors from a profit perspective are expected to be Energy (~5%), Staples (~6%), and Real Estate (~7%). While there is likely some optimism baked into current estimates, 2025 appears supportive for equities from an earnings growth perspective.
Positive Surprises Welcome
On balance, lofty equity valuations and the already strong economic backdrop would imply that equity returns could be challenged in 2025. It remains to be seen whether investors will continue to pay up for expensive equities after a strong 2024. Further profit growth from the overall market could help alleviate concerns, but equities are not cheap by most measures. On the economic front, it’s hard to get a big boost from strong data given that there isn’t much more room to improve. Question marks remain on technical backdrop with internal trends deteriorating as 2024 came to a close, but it is hard to get too bearish given the robust price action of the market leading Magnificent Seven. In our view, the market still appears attractive despite risks mounting, calling for a thoughtful investment approach while remaining alert to potential positive surprises in the economy and corporate profits.
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