In 2024, the U.S. equity market generated its third 20% plus annual return in the last four years. According to Dow Jones Market Data, the S&P 500 climbed 25%, and along with its 26% return in 2023, the broad U.S. stock index wrapped up its best consecutive years since 1997 and 1998: the leading up to the dot-com bubble.1
The “Magnificent 7” dominated returns in the first half of 2024, but broader leadership began to emerge in the second half of the year. Consumer discretionary, financial, and utilities sectors of the market meaningfully outperformed the S&P 500 in the second half of 2024. Returns for U.S. small cap stocks also beat the S&P 500 return during the period.
Over the past two years, annual inflation has fallen from 6.7% to 2.1%, as measured by Personal Consumption Expenditures (PCE) price index.2 During this period, economic growth increased by about 3% in 2023 and is expected to grow above 2% in 2024 and 2025. This surprisingly robust growth has stemmed primarily from positive supply-side developments, mainly strong productivity growth and a surge in the supply of labor. During the last two years ending in the second quarter of 2024, productivity increased by 4% and the labor supply grew by 1.8%.2
The 2024 election could bring significant policy changes that may impact the economy. Markets expect tax cuts, higher tariffs, reduced immigration, and deregulation. As investors begin analyzing the new administration’s policies, there is growing concern about the impact on the budget deficit. Current budget forecasts include the sunsetting of the Tax Cuts and Jobs Act of 2017. Permanently extending the TCJA tax cuts along with slower economic growth from aggressive tariffs would increase the deficit further. Concerns over the impact on interest rates and the U.S. dollar could hamper the new administration’s ability to pass key pieces of their agenda.
After two years of 20% plus equity market returns, U.S. stocks are expensive. Investor sentiment is surging, buoyed by easing inflation, Fed rate cuts, accelerating corporate earnings, and a favorable policy environment. This sentiment can be seen clearly when examining the surge in price-to-earnings (P/E). In 2024 alone, P/E expansion has accounted for 61% of the S&P 500 Index’s returns and 33% of the NASDAQ-100 Index’s gains. 3
S&P 500 valuations are now positioned in the 93rd percentile since 1990, and Nasdaq-100 valuations are slightly less stretched in the 82nd percentile since 2001.3 The 2024 S&P 500 rally also holds historical significance. As exhibit 1 illustrates, the rise in the S&P 500 in 2024 has been one of the strongest since 1928.
Figure 2
For U.S. stocks to move higher in 2025, earnings growth will need to broaden beyond the “Magnificent 7”. In figure 2, U.S. large cap stocks in general and the “Magnificent 7” stocks in particular, generated significantly higher earnings in 2023 and 2024. But that trend is expected to change. In 2025 and 2026, small cap stocks are expected to significantly out earn both mid cap and large cap stocks. Additionally, the growth earnings trend for the Magnificent 7 stocks is declining while the earnings for the “Other 493” are growing.
If these estimates are realized, small cap stocks could outperform mid and large cap stocks and the performance difference between the “Mag 7” and the rest of the S&P 500 stocks could shrink meaningfully.
In late 2024, stronger economic conditions coupled with persistent inflation led the Federal Reserve to take a more cautious approach to interest rate cuts. During its December meeting, the Fed reduced the short-term rate by one-quarter percentage point and decreased its projected rate cuts for 2025 from four to two. It is noteworthy that the risks for the upcoming year lean towards fewer rate reductions, or potentially none at all. Against this backdrop, rates are likely to stay higher for longer. While higher rates are positive for fixed income investors, they can put pressure on equity valuations and slow economic growth. As far as higher for longer goes, current interest rates are high relative to the past decade but from a long-term view, they are back to their historical average.
The global macroeconomic environment still supports fixed income investments. Most central banks are easing rates slowly, and while inflation risks exist, they are less severe. Long-term interest rates are expected to remain elevated but within a range throughout 2025. Even if rates remain high, current yields offer attractive income. In client portfolios, after raising duration in the fall of 2023, client portfolio durations stand at the 4.75 – 5.25 range, less than the 6.154 duration of the Bloomberg U.S. Aggregate Bond Index.
Spreads on investment-grade corporate bonds have decreased relative to U.S. Treasury bonds, making them more expensive. Despite this, interest rates may well remain elevated, supporting strong income in bond portfolios. The prospects for economically sensitive high-yield bonds and senior loans appear promising given their reliance on robust economic growth. Fewer rate cuts by the Fed further benefit senior bank loans which are floating rate based.
Municipal bonds enjoy strong and stable credit quality. State and local governments have solid balance sheets and ample liquidity; and the municipal market features attractive supply/demand dynamics. Additionally, the municipal bond yield curve remains steeper than that of U.S. Treasuries. A steeper yield curve indicates there is a larger incremental yield when investing in longer duration bonds.
After two years of strong market performance, equity market returns are expected to be more muted in 2025. In the first quarter, markets may experience higher volatility as investors digest the policy agenda of the new administration. With high equity valuations, investors may be quick to reduce exposure at the first sign of trouble. Portfolios with high equity market concentration in the best performing stocks over the last two years may suffer larger volatility than diversified portfolios.
We continue to maintain well diversified allocations for client portfolios. Our portfolios balance exposure to new market trends with the risks of fast-moving and sentiment-driven volatility. As we mentioned earlier, market participation will need to broaden for equity markets to produce positive returns. Client portfolios are underweight to U.S. mid and small cap, international developed and emerging markets stocks. We continually assess market trends and fundamentals to justify allocation adjustments.
Since 1979, U.S. small and large cap equities have alternated as market leaders, passing the performance baton across multi-year cycles. Over the past decade, U.S. large caps have surged ahead, outperforming U.S. small caps by an annualized 5.4%.5
Figure 3
Investors expect this trend will reverse. There have been several false starts during the last five years when inflation peaked, or when the Fed paused, or began cutting rates—the Russell 2000 rallied sharply, only to fade soon after. The sustainability of the most recent rally seen in the first half of November remains in question. U.S. small cap stock pushed higher under the premise the incoming administration would bring a shift in U.S. economic policies that benefit small caps. For small caps to win the tug of war in 2025, earnings expectations must rebound, supported by a solid economic backdrop.
We remain optimistic that U.S. small cap stocks may outperform in 2025 but are waiting for technical confirmation in the figure 3 chart. A break of the red line to the downside indicates high probability that fundamentals are beginning to favor strong relative performance for the Russell 2000 Index versus the S&P 500 Index.
At this point we would increase the U.S. small cap exposure and decrease the U.S. large cap exposure. The factors boosting after-tax corporate profits in the U.S. are less apparent in European, Japanese, or emerging equity markets. Japan has increased average shareholder returns through higher corporate profitability, but its economy remains low growth due to high public debt and poor demographics. Europe faces demographic issues, a nearby war, and an energy transition. It lacks the political will for significant fiscal or monetary stimulus to boost domestic demand or improve average returns on capital. However, equity valuations are significantly cheaper than in the U.S. and any positive developments could have a strong impact on stock prices.
China faces major challenges heading into 2025, including a real estate crisis that has hurt consumer confidence and a potential trade war with the U.S. that could slow growth significantly. Despite recent efforts by the central government to stimulate the economy, structural issues remain unaddressed. Investor expectations have fluctuated, and 2025 may bring similar uncertainties.
Strong market performance over the past two years has left valuations elevated in certain markets and portfolios unbalanced by asset class, sector and style and region. Large unrealized capital gains have made rebalancing taxable accounts more difficult.
The idea of "correct" portfolio construction is now questioned. Diversification is less popular since some assets, like stocks over bonds and U.S. investments over international ones, have outperformed for multiple years. Many investors believe the past winners will continue to produce superior returns. However, it will be important to maintain adequate exposure to areas of the markets that have lagged and underperformed along with the winners in a well-diversified portfolio. Investment trend shifts happen quickly changing portfolio outcomes. Properly diversified portfolios reduce tail risk by having exposure to more diverse asset classes.
Investing in 2025 will be complex and difficult. With expensive stock and bond markets, the potential for and speed of change is quite high. The new administration has an aggressive policy agenda and what will and will not get passed remains to be seen. Each of these policies alone increases the uncertainty facing investors, while dealing with multiple policies shifts creates complexities that will be difficult to forecast. Like central banks, we remain data dependent and alert to various potential paths for the economy and financial markets from here.
Footnotes:
1 – “Stocks Cap Best Two Years in a Quarter-Century”, Karen Langley, Wall Street Journal, December 31, 2024
2 – “Vanguard economic and market outlook for 2025: Beyond the landing.”, Vanguard Research, December 2024
3 – “The Fed Is Battling the Bond Market. How to Avoid the Knife Fight.”, Darren Fonda, Barron’s 12/26/2024
4 – Morningstar Direct
5 – “2025 Investment Outlook, Animal Spirits Awaken”, Innovators ETFs, December 2025
Index Descriptions:
The Standard and Poor's 500 Index, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.
The Russell 2000 Index is a small-cap U.S. stock market index that makes up the smallest 2,000 stocks in the Russell Index. It was started by the Frank Russell Company in 1984. The index is maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.
The Bloomberg U.S. Aggregate Treasury Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar denominated, fixed-rate taxable bond market. This includes treasuries, government related and corporate securities, mortgage-backed securities, asset-backed securities and collateralized mortgage-backed securities.
The Personal Consumption Expenditures (PCE) includes a measure of consumer spending on goods and services among households in the U.S. The PCE is used as a mechanism to gauge how much earned income of households is being spent on current consumption for various goods and services.
The Nasdaq-100 is a stock market index made up of equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange.
Magnificent 7 - Apple, Microsoft, Google parent Alphabet, Amazon.com, Nvidia, Meta Platforms and Tesla.