December 2024 Market Commentary

Up, Up, and Away

◉Markets roared back after the U.S. elections as investor animal spirits were rekindled.
◉Proposed tax cuts may boost corporate earnings in 2025.
◉​​​​​​​Investors' risk appetite swells, but several key risk factors lie ahead.

The S&P 500 Index and the Dow Jones Industrial Average posted their best monthly returns of the year in November, shaking off pullbacks in October. With a 10.6% gain in November, the Russell 2000 Index pushed its one-year return to 36.4%, besting the U.S. Large Cap Indices. Non-U.S. markets declined for the second consecutive month. All 11 S&P 500 Index sectors generated positive monthly results in November, with Consumer Discretionary and Financials posting double-digit gains.

Animal Spirits

John Maynard Keynes introduced the term "animal spirits" in his 1936 book, The General Theory of Employment, Interest, and Money. Keynes was referring to emotional mindsets that influence human behavior, particularly in economic decision-making. He contended that economic decisions are influenced not just by rational calculations of expected returns and objective data, but also by human psychology, emotions, and confidence, which play a crucial role in driving economic activity.

Keynes wrote "our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing." In such an uncertain world, many decisions "can only be taken as a result of animal spirits."[i]

The concept of animal spirits has since become a fundamental part of behavioral economics, helping explain why markets can sometimes behave irrationally due to human emotions like fear, optimism, and confidence. Alan Greenspan, the former Chairman of the Federal Reserve, famously used the term "irrational exuberance" in a speech on December 5, 1996. Greenspan cautioned that the stock market might be overvalued due to unfounded market optimism driven by psychological factors rather than economic fundamentals. In the prior 24 months leading up to Greenspan's speech, the S&P 500 Index posted a 75% return, with monthly gains in every month but two. Markets initially sold off following Greenspan's comments and see-sawed throughout December, before closing down for the month. However, animal spirits renewed with a vengeance thereafter with the S&P 500 Index doubling over the last three years of the 1990s.

Déjà vu

Considering the impressive surge in U.S. stocks this November, the Republicans' sweep in last month's U.S. elections may have rekindled investors' animal spirits. As we noted in last month's commentary, single-party rule in the United States has been rare in the last few decades, occurring just five times since 1980. The surprise sweep likely caught some investors off guard.  Some investors seemed to quickly reposition portfolios post-election in an attempt to fully grasp the market implication of a pro-business agenda featuring corporate tax cuts and deregulation. J.P. Morgan reported that individual investors sunk more than $9 billion into exchange-traded funds and individual stocks the week after the election. The buying, noted the bank's analyst team, was 3.2 standard deviations above the average for the past 12 months, marking the biggest inflow since March 2022.[ii]

The escalated buying interest post-election is noteworthy because the S&P 500 Index gained 20+% in the first 10 months of 2024. Leading up to the election, the economic backdrop was encouraging. U.S. GDP trended higher than expected, inflation was falling, and unemployment remained low. In September, the Federal Reserve initiated a rate cut, the first of many expected cuts over the next two years. With the U.S. stock market at all-time highs conventional wisdom suggests the "good news" is priced into the market. How much better could it get for investors?

Historic Tax Cuts in 2017

The new administration's proposal to lower the corporate tax rate may have bolstered investor confidence. Reduced taxes lead to higher earnings, potentially driving up stock prices. Fortunately, investors can look to recent examples for evidence of this effect.

When the 2017 Tax Cuts and Jobs Act (TCJA) went into effect in 2018, the U.S. corporate tax rate was slashed from 35% to 21%.  It marked the most significant overhaul of federal tax rules in three decades. Before the TCJA, corporations in the top tax bracket had been taxed at a rate of 35% since 1993.

[iii]

The effective U.S. corporate tax rate fell from 28% in the five years prior to the tax cut to 18% between 2018 and 2023. At the sector level, utilities, staples, and technology were the biggest beneficiaries.[iv] The Congressional Budget Office (CBO) projected that corporate income tax revenues as a percentage of U.S. GDP would drop for four years before matching pre-TCJA levels in 2023. In addition, the CBO projected the figure to exceed 2017 levels in 2023. As the graph below shows, actual revenues were lower than projected from 2018 to 2020, but higher than projected in 2021 and 2022. The S&P 500 Index, undeterred by tax revenue projection shortfalls, doubled from 2018 to 2023, a 12% annualized return.

A Proposed Lower Corporate Income Tax Rate

President-elect Trump proposed a further reduction from 21% to 15%, specifying this would apply to companies that make their products in America. Meera Pandit, a Global Market Strategist at J.P. Morgan, estimated that 145 companies in the S&P 500 Index could benefit from the proposed tax rate change. Pandit indicated that 51 of the 145 companies are in the services sectors (Financials, Health Care, Communications Services). While Pandit did not quantify the impact to earnings, Ned Davis Research estimated that the S&P 500 Index's after tax income may rise by 4.7%. Wall street strategists expect the bellwether index to rise by 9% next year. It is worth noting that the stock market has outpaced earnings growth the last two years. If the trend continues and strategists are correct with their forecasts, we may see a third consecutive year of double-digit gains.

"Those who have knowledge, don't predict. Those who predict, don't have knowledge."

-Lao Tzu

To blindly follow strategists' price targets would be imprudent. A year ago, the average Wall Street strategist 2024 year-end price target for the S&P 500 Index was 4,861, representing a 2% potential return. The outlook seemed inadequate considering the yield on a 12-month U.S. T-Bill was 4.78%. A pragmatic investor would surely go the risk-free route and buy the T-Bill. However, as the graphic below depicts, foregoing the stock market in 2024 meant missing a 24% incremental return.

Looking Ahead

Election uncertainty is behind us, but policy uncertainty lies ahead. History suggests that campaign rhetoric does not always match policy. Nevertheless, we do expect meaningful policy action in the new administration's first 100 days. Election aside, the U.S. economy is remarkably resilient. Third quarter GDP grew at an annualized rate of 2.8%, with personal consumption growth accelerating from a 2.8% annualized rate in the second quarter to 3.7% in the third quarter.

Sticky inflation remains a concern with CPI ticking up slightly to 2.6% in October vs a 2.4% rate in September. Despite the rise in inflation, the Federal Reserve reduced the Federal Funds Rate by 25 basis points (1 basis point = 0.01%) at the November meeting and is expected to cut rates by another 25 basis points at the December meeting.

The outlook for corporate earnings is bullish, with analysts expecting fourth quarter and full-year 2024 earnings growth of 12% and 9%, respectively. For 2025, earnings are projected to grow 15%. The S&P 500 Index is not terribly expensive trading at 22 times 2025 estimated earnings, but the index's P/E ratio has increased 25% over the past two years reflecting a growing investor appetite for risk.

Heading into 2025, several key risk could impact the stock market including changes in fiscal and monetary policies, persistent inflation, geopolitical tensions, and shifting consumer and business confidence. While most of the risks are repeats from prior years, policy risk stands out as one to watch next year. If the new administration's pro-business agenda plays out with additional tariffs, lower taxes, and tighter immigration laws, inflation may trend higher. Higher inflation may disappoint stock and bond investors, as the futures market has priced in approximately 80 basis points of additional rate cuts through the end of 2025. Valuations and investor sentiment suggest little regard for negative outcomes in 2025. Effective risk management calls for regularly assessing market conditions and adjusting investment strategies to mitigate potential losses while maximizing returns. We believe an active risk management strategy is vital to long-term investment success.