January 2025 Market Commentary

A Year in Review

Despite a soft December, U.S. equity markets posted exceptional results for the second consecutive year. Once again, stock market returns exceeded consensus expectations. Results for 2024 were similar to 2023 with the Magnificent Seven stocks driving most of the S&P 500 Index's results. The Fed started an interest rate easing cycle, but inflation concerns pushed yields higher. 2025 looks like a banner year for earnings growth but risks should not be ignored.

The U.S. equity markets cooled in December with the Dow Jones Industrial Average posting its worst December performance since 2018.  After posting a 10.6% gain November, the Russell 2000 Index dropped 8.3% in December. Ten of the 11 S&P 500 Index sectors generated negative monthly results in December, with Consumer Discretionary the standout performer with a 0.9% gain. Materials and Energy dropped by double-digits last month.

"Bull markets are born on pessimism, grow on skepticism, mature on optimism, and die on euphoria."

-Sir John Templeton

2024 Review: cautiously optimistic

A year ago, we were cautiously optimistic about the stock market while overall market sentiment reflected extreme investor optimism as measured by the CNN Fear & Greed Index. That index is a compilation of seven different indicators which measures some aspect of stock market behavior. The index captures the mood of the market, ranging from extreme fear to extreme greed. A year ago, the index indicated an extreme greed level.

Analysts at the time expected S&P 500 Index earnings to grow 11.5% in 2024, a meaningful improvement from 2023's 1% growth rate. Our caution stemmed from two factors: valuation and concentrated market leadership. The stock market traded at a premium to longer-term valuation metrics, like price-to-earnings, price-to-sales, and price-to-cashflow ratios. Some strategists argued that the high valuations were justified because of accelerating corporate earnings. But much of the accelerated growth was expected to come from just a handful of stocks. Similar to 2023, the so-called "Magnificent Seven" stocks (Amazon, Apple, Alphabet, Meta, Microsoft, NVIDIA, and Tesla) were anticipated to be the primary drivers of the S&P 500 Index's earnings growth in 2024. The Magnificent Seven accounted for 65% of the S&P 500 Index's return in 2023 and 28% of the index's market value. Replicating 2023's performance seemed like an illogical ask despite the excellent earnings growth rate.

2024 Review: The Scorecard

In 2024, the S&P 500 Index achieved a 25% return, marking its best two-year performance in 25 years with a cumulative return of 58%. Gains were unevenly distributed last year, with only three of the 11 sectors outperforming the index. The top-performing sectors were Communications Services, Financials and Consumer Discretionary. In contrast, Materials saw a decline, while Energy, Consumer Staples, Real Estate, and Healthcare each posted single-digit percentage gains. The clear standout performers in 2024 were once again the Magnificent Seven stocks. Despite the median return for the group dropping from 81% in 2023 to 44% in 2024, the Magnificent Seven stocks contributed 57% of the S&P 500 Index's gains versus a 65% contribution in 2023.

Only 31% of the S&P 500 Index stocks outperformed the index, highlighting the lack of market breadth for the second consecutive year in 2024. Additionally, 31% of the stocks in the index posted negative returns last year. If 2024 was expected to be the year of the stock picker, the results suggest otherwise.

2024 Review: the Fed takes action

The Federal Reserve Bank (the Fed) took decisive actions last year to manage economic stability by implementing three rate cuts and actively managing its balance sheet. In September, the Fed announced a 50 basis point (100 basis points equals 1%) reduction in the Federal Funds Rate, its first rate reduction in over four years. The Fed followed up with a 25 basis points cut in November and another 25 basis points cut in December. Concurrently, the Fed reduced its holdings of Treasury and agency mortgage-backed securities, decreasing its balance sheet by approximately $400 billion, from $7.5 trillion to $7.1 trillion. At its peak, the Fed's balance sheet grew to nearly $9 trillion.

Coming out of the December meeting Fed officials notably appeared to scale back 2025 rate cut plans. Multiple Wall Street strategists described the Fed's December action as a hawkish cut, suggesting that the market should be ready for a pause rather than immediate future rate cuts. The Fed's Summary of Economic Projections revealed that the Federal Open Market Committee is anticipating two 25 basis points cuts in 2025, down from the four projected in September. J.P. Morgan Wealth Management provided the following key highlights from the meeting in a research report published after the December meeting:[i]

• Growth: The Fed increased its GDP growth forecast to 2.5% for 2024, indicating a stronger economy than anticipated.
• Inflation: The Fed raised its inflation projections for next year by 40 basis points to 2.5%.
• Policy Path: The Fed raised its expectations for future policy rates by 50 basis points in both 2025 and 2026.

[ii]  

The report notes that the Fed will be cutting rates at a slower pace for mostly good reasons. Economic growth has been stronger than expected, the job market remains healthy, and there is little near-term recession risk. Of concern, however, is a stubbornly persistent inflation rate.

Looking Ahead: 2025

Bank of America's Securities Data Analytics team published a research note this week titled "One step closer to euphoria." In the note, the team shared that their proprietary Sell Side Indicator (SSI) increased to 57% in December, one percentage point shy of triggering a Sell signal. The SSI is a contrarian sentiment signal that tracks sell side strategists' average recommended allocation to equities in a balanced fund. As stated in the note, the SSI has been a reliable contrarian indicator. In other words, it has been bullish when Wall Street was extremely bearish and vice versa.

The SSI reached its highest level since early 2022 and has not declined for eight consecutive months, its longest streak since 2021. In addition, the data analytics teams stated that several other sentiment gauges point to elevated levels of bullishness. The bank's Fund Manager Survey showed a big rotation from cash to equities last month, with 30% of respondents expecting U.S. equities to be the best performing asset class in 2025. The research note indicated that 53% of consumers expect stocks to increase over the next year based on the Conference Board's survey, just off an all-time high.

10 for 10

Wall Street strategists are forecasting 10% growth in earnings and a 10% rise in the S&P 500 Index for 2025, according to the data presented in the table below. In our opinion, that earnings forecast looks reasonable. According to Factset Research, a "bottom-up" analysis of analyst estimates for the companies within the index indicates a projected earnings growth rate of 15% for 2025.

However, forecasting stock prices is far from simple. We reviewed the last 20 years of forecasting and found strategists had limited success, but patterns of recency bias emerged. Comparable to Bank of America's SSI, the forward one-year price targets were often contrarian indicators when Wall Street was extremely bullish or extremely bearish.  Like Wall Street, Main Street investors also face the risk of complacency at both extremes of the investor sentiment spectrum. They are not prepared for sudden market reversals due to over confidence or over pessimism.

We find little value in hanging our hat on Wall Street's one-year outlook. We are encouraged by the prospect of 10% to 15% earnings growth and an expected higher participation rate from the non-Magnificent Seven stocks. Goldman Sachs projects the remaining 493 companies in the S&P 500 Index will see a 12% increase in earnings this year.

We are also encouraged by comments made by Federal Reserve Bank Chairman Powell last month about the U.S. economy. He stressed that the economy is in "a really good place" and that it has "made great progress" throughout 2024. If the Fed continues to gradually ease rates in 2025, the probability of earnings growth reaching 10% may increase.

As we stated last month, U.S. 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, but pockets of concern do exist.

December's economic data presented a mixed picture as we closed out 2024. Inflation continued to cool, with Core CPI rising 3.3% in November, aligning with expectations, while headline CPI increased 2.7%. Housing costs remained the primary driver of core inflation but showed signs of slowing, and sector-specific pressures, such as higher motor vehicle insurance and education costs, contrasted with more subdued growth in categories like recreation.

Meanwhile, the labor market remained resilient, as November saw 227,000 nonfarm payroll additions, with significant gains in healthcare, leisure, and government jobs. However, retail trade experienced notable declines, and the unemployment rate held steady at 4.2%.

 As we flip the calendar to 2025, several key risk factors are holdovers from the prior year: changes in fiscal and monetary policies, persistent inflation, geopolitical tensions, and shifting consumer and business confidence. If the new administration's pro-business agenda plays out with additional tariffs, lower taxes, and tighter immigration laws, inflation may trend higher in 2025. We cannot predict how tariffs will be implemented but do remember that stocks reacted negatively to the tariff wars in 2018 and 2019. And now bond markets have reacted negatively to the potential for higher inflation and potentially larger fiscal deficits.

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.  

We appreciate your confidence and support and encourage you to reach out to an Old Point team member with any questions. Here's to a happy, healthy and prosperous New Year!