‘Irrational Exuberance’ gets a taste of reality
After Trump’s landslide victory, the S&P index had a bullish run, ending November 5.3 percent higher than the end of October. Former Fed Chair Alain Greenspan used the term ‘Irrational Exuberance’ to describe the market sentiment before the dotcom bubble. Indeed, the overvaluation of the S&P 500 index in November was driven by over-optimistic market sentiment rather than the economic fundamentals.
December 2024 also had a strong start. The markets were unfazed by a possible government shutdown. The US government averted a shutdown but did not increase the federal borrowing limit, as called by President-elect Trump. US government debt currently stands at about $36 trillion.
The optimistic mood changed following the Fed meeting on 17-18 December. After the announcement of the 25 bp rate cut, the S&P 500 index closed 3 percent lower than the previous day. Investors perceived the hawkish rate cut as an indicator of the things to come. Analysts have started pricing in two small rate cuts in 2025, rather than four, as previously expected.
Although the US economy remains resilient despite the slowly cooling labor market and inflation, the current bull market appears to be focussing more on the positive aspects of Trump’s political agenda. Trump’s pledge to lower corporate taxes and increase protectionism against Chinese imports appears to favor US companies. However, the semiconductor sector and companies that rely on imported intermediate materials would pass their cost increases to consumers, putting upward pressure on consumer prices.
Without curbing government spending, cutting corporate taxes would also lead to a bigger budget deficit and higher borrowing costs. Overall, it remains to be seen if the pros of President-elect Trump’s policies outweigh the cons, to justify the bull market.
PMI and consumer outlook deteriorate
The Chicago Purchasing Managers’ Index (PMI) dropped to 36.9 in December from 40.2 in November. This was below the market anticipation of 42.5. The index’s long-term average from 1967 to 2024 is 54.7. Hence the current value indicates a contraction in business activity. December’s contraction for the 13th consecutive month was the steepest decline since May.
The Conference Board’s consumer confidence index declined by 8.1 points in December to 104.7 (1985=100). The Present Situation Index—based on consumers’ assessment of current business and labor market conditions—fell to 140.2 (1985=100) from 141.4 in November. Furthermore, the Expectations Index—based on consumers’ short-term outlook for income, business, and labor market conditions—fell sharply to 81.1 (1985=100) from 93.7 last month.
A reading above 80 for the Expectations Index would indicate that consumers are not concerned about a recession. Although the index remains over 80, the monthly deterioration is significant. The recent fall in consumer confidence indices reflects concerns about the business conditions rather than the state of the labor market.
Two more small rate cuts in 2025
In the latest data release, the Federal Reserve’s preferred metric — the personal consumption expenditures price index increased at an annualized rate of 2.5 percent in November from 2.4 in October. This was slightly lower than the market analysts’ projection.
The US economy continued to grow at a respectable pace in the third quarter. US GDP growth for 2024 Q3 was revised up to 3.1 percent from the previous estimate of 2.8 percent (Source: The Bureau of Economic Analysis.)
On December 18, 2024, the Fed lowered interest rates by 25 basis points. This reduced the target interest rate range to 4.25% to 4.5%. The Fed remains committed to achieving maximum employment and price stability.
The Fed’s dot plot is a chart that records each Fed official’s projection for the central bank’s key short-term interest rate. This chart is updated every three months. Going forward, Fed chairman Powell reiterated monetary policy decisions will continue to be made on a ‘data-dependent’ basis.
Markets perceived December’s rate cut as hawkish and not aggressive enough as in the 50-basis-point reduction in September 2024. Back in September, the risk of higher unemployment was a more pressing issue than the sticky inflation. In December, the strength of the economy and the labor market changed the focus on the inflation target again.
US policymakers project 2025 year-end GDP growth as 2.1%. The core inflation forecast was revised up to 2.5% from 2.1%. In light of the sticky inflation and respectable GDP growth rate, we believe that the Fed will not be hurrying to cut the interest rates. We expect the Fed to keep the rates on hold in its January 29 meeting.
S&P 500 index remains overvalued
According to Factset Insights from December 20, the forward 12-month P/E ratio for the S&P 500 is 21.4. This P/E ratio is above the 5-year average (19.5) and above the 10-year average (18.0).
We believe the S&P 500 index is currently in the bubble territory. Following Trump’s victory, the prevailing optimistic sentiment may continue in early 2025. However, the sharp contraction in business activity as indicated by the Chicago Purchasing Managers’ Index (PMI) is a reason for concern. Despite the deterioration in business activity, we expect the Fed not go ahead with a rate cut in January.
Our monthly S&P 500 forecast is a model-based fair-value estimate. Based on the economic fundamentals our forecasts indicate a slight drop in December. Irrational momentum-driven rallies are beyond the scope of our model.
The possible impact of geopolitical tensions is fed into the model through keyword searches (Google clicks) and the advanced retail sales index. However, these variables perform better in normal times. Our quarterly S&P 500 forecast discusses these issues in more detail.