This is the season when investment strategists publish their outlooks and forecasts for the coming year. This year, the message from investment banks is mostly the same: “We are bullish for stocks in 2025, but there are these policy risks of the new Trump Administration.”
This time last year, I expected returns of about 12% for the S&P 500, which is the average return during an election year. The S&P 500 has more than doubled that figure on a YTD basis. This year, I am expecting equity returns to be flat or in the low single-digits. I am cautious for 2025, but not bearish.
The main headwind facing stocks is valuation. The S&P 500 is trading at a forward P/E of 22, which is highly elevated by historical standards and ahead of the P/E valuation when Trump first took office in 2017. This doesn’t mean that the stock market can’t rise, but earnings growth will have to be the driver of price growth. Investors shouldn’t expect P/E expansion to boost stock prices. The combination of elevated valuation and no recession on the horizon that craters earnings expectations translates into a roughly flat stock market in 2025.
“This will not end well” warnings
Students of market history are well aware that valuation matters to equity returns over time horizons of less than 5–10 years. Elevated valuation can only be regarded as a “this will not end well” warning for equity investors.
I am seeing other “this will not end well” warnings with no obvious immediate bearish triggers.
As an example, Warren Buffett’s Berkshire Hathaway reported an unprecedented cash hoard of $325 billion for Q3 2024, which rose by $48 billion compared to Q2 2024. Cash levels are at record highs, even when normalized by total assets, and exceed the reserves built ahead of the GFC. When questioned, Buffett responded, “We don’t have any idea how to use it (cash) effectively.”
As the accompanying chart shows, Berkshire’s cash levels tend to spike ahead of periods of significant market dislocation, such as the Dot-com crash and the GFC. On the other hand, it is an inexact market timing indicator.
Other indicators of market excesses can be seen in the fixed income markets. Mark Zandi, chief economist at Moody’s Analytics, observed that “the high-yield corporate bond yield spread is wider than the fixed rate mortgage spread”.
As another sign of the times, volumes on leveraged ETFs are spiking, which is a contrarian bearish condition with no obvious trigger.
No sell signals in sight
In summary, I am seeing signs of froth in risk appetite. However, I am not seeing any immediate bearish triggers that warrant defensive portfolio positioning.
From a technical perspective, market breadth is strong, which argues for a continued stock market advance. Both the S&P 500 and the NYSE Advance-Decline Lines made all-time highs last week. If history is any guide, the A-D Line turns down several months ahead of a major market top.
Similarly, my long-term market timing model hasn’t flashed a sell signal. This model buys when the monthly MACD turns positive and sells when the 14-month RSI flashes a negative divergence. RSI is nearing an overbought condition, which is a pre-condition for a sell signal, but there are no signs of a lower RSI on higher stock prices that is the basis for a sell signal.
As well, the high yield market is not flashing any signs of distress. I use high yield as an “extreme” equity risk premium indicator to measure the level of stress in the higher-risk portion of the equity market.
The accompanying chart shows the high yield spread plus a notional 5-year Treasury yield (blue line), the actual high yield index (red line) and the NASDAQ 100 (black line) as a measure of the higher risk and higher reward part of the U.S. equity market. Historically, rising funding costs, or equity risk premiums, have risen sharply in conjunction with major bear markets. While funding costs have slightly edged up, readings are nowhere near levels that signal distress.
Cautions, but not bearish
In conclusion, I would describe my 2024 U.S. equity view as cautious, but not bearish. The U.S. market is facing a number of “this will not end well” valuation-based warnings. However, I see no immediate bearish triggers that warrant defensive portfolio positioning. I am therefore expecting S&P 500 returns to be roughly flat or in the low single-digits for 2025.
This view is consistent with
Ryan Detrick’s observation that the third year of bull markets, which we are in, tends to be weak. If the bull market were to continue, 2026 and 2027 should be strongly positioned.
In addition, Mark Hulbert highlighted a similar valuation warning based on Value Line’s estimated 3-5 year appreciation of the stock market (VLMAP).
The latest reading VLMAP stands at 35%, which has historically led to subpar returns in the year ahead.
Equity returns in 2025 is likely to be accompanied by above average volatility. Trump’s surprise announcement that he would impose a 25% tariff on Canada and Mexico, along with an additional 10% on China the first day he takes office, is a preview of the probable volatile market environment. Along with the headwind of the of elevated equity valuations against a backdrop of continuing non-recession growth, this makes the risk-adjusted U.S. equity outlook challenging for 2025.
Hi
What is interesting is that the Buffett cash as % of assets after 2000 crash dropped close to an all time low and pretty much immediately thereafter, he started to raise cash.
After the GFC, he was in the market for a much longer time. I suppose he pays attention to ERP (earnings risk premium), or E:P ratio. For now, fixed income yields are challenging stock yields (total return). Buffett probably expects bond yields to creep higher going forward that may prove to be a trigger for equity sell off.
FWIW, it has been raining cash in the fixed income market, no doubt about it and I suppose Buffett is making full use of this opportunity.
How about alternatives to the S & P 500? Anyone is seeing small caps or other options as a better choice? Cam already commented about gold. Bonds do not look attractive to me
There is alpha to find for astute analysts and portfolio managers. This means passive indexes will underperform these active managers. Find those that are outperforming from the election day onward and use them.
There is a giant sorting of winners and losers in this new world. Another way of seizing outperformance is by using a long only momentum fund. These are all outperforming this year and they continue to outperform since the election. Straight price momentum ETFs like MTUM that are weighted to large companies, are not doing as well as FDMO (my second fav)that uses fundamental momentum as well as price. Also, MTUM is very Mag 7 weighted and the market strength is broadening out. My favorite is VFMO that is more equal weighted and will even own larger small caps. DWAS is the small cap momentum that does better than the Russell 2000. It is doing great but I’m not using it even though I would if I was simply performance oriented.
I recommend subscribing to Yardeni Quicktakes. He is an eyes-wide-open strategist who has been the most correct of any newsletter writer by being consistently positive. But he is VERY aware of the things that will end the party.
My outlook for 2025 is for a major bear market to start somewhat after inauguration when GOP policies will be announced.
Investors are celebrating a hedge fund manager being appointed to head the policy control National Economic Counsel. But Kevin Hassett has been very critical of running 6% deficits when the economy is strong. Search out his YouTube video interviews and articles. All Strategists believe the deficits are heading things to a bad outcome. He will have policies to rein them in while at the same time reducing corporate taxes and other Trump tax handouts from the campaign. This along with Musk’s DOGE spending slashing will send the economy into a recession, possibly deep.
Hassett correctly has said the bull market was goosed by 6% deficits to get the DEMs re-elected. He will unwind that. Logical policies of government spending are great for the long-term but are painful short-term. The Plan 2025 looks to dismantle so much of Federal bureaucracy, all well and good but ….
Richard Koo, the great economist of the Japanese economy says the Japanese government caved into international pressure every decade or so, to balance their budget after running big deficits. They slashed government spending. Instead of the deficit falling, it surprised by going up. Tax revenue fell sharply in the ensuing recession and unemployment insurance and other automatic support spending went up. They quickly reversed course.
This will happen in America too. The best laid plans have unintended consequences.
To pass the 2017 tax cuts and other goodies, the GOP must make its budget revenue neutral. This will include major tariffs to raise money on the backs of consumers (inflationary) The budget will also make evident the cost slashing they will need to target. It will be obviously recessionary.
The spending cuts are necessary in the long run but it’s like chemotherapy is necessary to fight cancer but its nasty until the cure happens.
Thanks a lot Ken!
Wow Ken, this is a no nonsense bearish call. I pay attention to what you write. Back a few years ago, you had introduced this group to an investment advisory from Montana and they are equally bearish too.
All I can say is thank you, on this TG weekend.
Who is this investment advisory from Montana? Can you share the info?
It is called Investech. They have been bearish for a few years now and have missed out on significant recent gains. However, their goal is “safety first”. Their goal is to save massive bear market losses but cutting stock market exposure. Such macro timing may not always work. Here is a link you may want to check out. http://online.wsj.com/article/SB10001424052702303851804579560170046544420.html?reflink=desktopwebshare_permalink