As we approach the end of the year, the outlook for stocks remains generally positive, buoyed by a macroeconomic backdrop that has stabilized following the unprecedented challenges of recent years. Economic growth, though modest, continues to provide a solid foundation for corporate performance, while inflation, despite falling significantly from the highs seen in 2022, remains above pre-COVID levels. This environment has maintained a relatively supportive foundation for equities, though it also underscores potential headwinds in the years ahead. Nonetheless, the present economic picture is strong enough to encourage continued optimism as corporate earnings reports remain resilient, providing a boost to animal spirits.
However, the story of corporate earnings is increasingly one of division—a bifurcated landscape in which a few mega-cap companies dominate, while many smaller firms and sectors trail behind. The market has evolved into what many are calling a “winner-take-all” environment. At the forefront are the “Magnificent Seven” companies—mega-cap technology and consumer giants that continue to see robust earnings growth and expanding profit margins. This elite group, along with a few other top players, has effectively driven the majority of the market’s overall earnings and performance gains.
By contrast, the rest of the market has experienced much slower growth, resulting in a widening gap between these top performers and the rest of the pack. For example, on a trailing 12-month basis ending June 30, Apple makes more net income than the entirety of the Russell 2000!
This concentration of earnings and profitability presents risks for investors as it leaves the broader market more vulnerable to sector-specific downturns, especially in big tech. For now, consensus expectations point to a broadening out of fundamentals and a reacceleration in profit growth for companies outside of the Magnificent Seven. The current earnings season should illustrate whether the market is on the right track. In our view, so far so good.
Valuations in the market are another point of concern.
Stock prices, by nearly any metric, remain elevated compared to historical norms, which can heighten the risk of volatility. However, there is a critical factor that has helped justify these valuations: corporate profit margins. Companies are more profitable than they were a few decades ago, largely due to technological advancements, leaner business operations, and other structural efficiencies. This trend in profitability has given many firms a strong buffer, helping them to absorb economic shocks and maintain operational efficiency even when growth slows. In this sense, while valuations are high, they may remain somewhat sustainable given the profitability environment. Perhaps this new era of corporate profitability has led to valuations carrying less weight among investors than they have historically. Of course, valuations may just not matter until they inevitably do. We are hesitant to make such a declaration, but it is difficult to ignore that valuation extremes have continued to persist.
With relatively favorable economic conditions and corporate performance, the market’s biggest risk may come from external, underpriced events. Global tensions have weighed on investor sentiment but have yet to produce significant market disruptions. The ongoing war between Russia and Ukraine is now well into its second year. Similarly, the ongoing conflict between Israel and Hamas, along with the heightened risk of Iran’s involvement, creates a potential for a larger scale conflict. While markets have absorbed these issues thus far, they remain points of vulnerability, with the potential to trigger market corrections if the conflicts escalate.
In the U.S., an underlying risk is the uneven economic recovery, which has increasingly become a case of “two economies.” The wealthiest Americans continue to experience job growth, rising income, and expansion in their net worth, while those at lower income levels struggle to make gains. This wealth gap not only creates potential social and economic issues but also poses longer-term risks for consumer spending and economic stability, as broader participation in economic gains is often a key factor in sustainable growth.
Election Day in early November has investors pricing in higher volatility despite indications from polls and betting markets that Donald Trump is favored to win. As of October 29, Polymarket, FiveThirtyEight, Kalshi, and PredictIt are expecting a Donald Trump victory. That said, as the 2016 election cycle illustrated, polls and expectations have been caught offsides before. This likely justifies the persistent bump in the VIX curve being at odds with consensus election results presently priced in. With a Republican Sweep also seemingly consensus, positive momentum for Democrats on election day is unexpected. With faith in polling and betting markets for election outcomes deteriorating, it seems justified to stay nimble heading into election day.
Overall, while the outlook for stocks remains favorable as we approach year-end, the market’s reliance on a concentrated group of companies and the specter of unpredictable external shocks suggest a level of caution is warranted. A durable second wave of inflation could rise from larger scale conflicts abroad and could hamper forward equity market returns. The combination of these factors highlights the need for diversified strategies and an awareness of both economic strengths and vulnerabilities. Investors would be wise to monitor geopolitical developments closely, along with the structural divides within the U.S. economy, as these factors may play increasingly critical roles in shaping market dynamics going forward.
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Any indices and other financial benchmarks shown are provided for illustrative purposes only, are unmanaged, reflect reinvestment of income and dividends and do not reflect the impact of advisory fees. Investors cannot invest directly in an index.
Except where otherwise indicated, the information contained in this presentation is based on matters as they exist as of the date of preparation of such material and not as of the date of distribution or any future date. Recipients should not rely on this material in making any future investment decision. The performance data quoted represents past performance. Past performance does not guarantee future results. Current performance may be lower or higher than the performance data quoted.
Glossary:
Consumer prices (CPI) are a measure of prices paid by consumers for a market basket of consumer goods and services. The yearly (or monthly) growth rates represent the inflation rate.
Cyclically Adjusted Price Earnings Ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities and serves as the foundation for a wide range of investment products. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
The Consumer Confidence Index (CCI) by the Conference Board is a key economic indicator that gauges the level of optimism (or pessimism) consumers feel about the overall economy, based on their current and future financial conditions and perceptions. Released monthly, it reflects: 1) Present Situation Index: Measures consumers’ appraisal of current business and labor market conditions. 2) Expectations Index: Gauges consumer expectations for economic conditions over the next six months.