2025 Q1
January 2nd, 2025
Our quarterly S&P 500 forecast for 2025 Q1 (average price returns) indicates a 6.6 percent growth over the previous quarter. Our monthly forecast for January is lower than December’s average. Geopolitical problems such as the Russia-Ukraine, and the Israel-Palestine conflict cannot be captured in a forecast model. Thus, any uncertainty concerning these issues makes the 95 % confidence interval around the point forecast rather wide.
S&P 500 records the biggest 2-year gains since 1998
After the impressive 2023 performance of 24 percent growth, the S&P 500 index closed 2024 with another remarkable 23.3 percent gain over the previous year. This marked the best two-year in-a-row performance since 1998. The stronger-than-expected economy, rate cuts, and the AI revolution were the driving forces of the two-year rally.
Following Trump’s landslide victory in the presidential election, the S&P 500 market rally gained strong momentum. The S&P 500 gained 5.3 percent in November over the end of October. The market rally was based on an optimistic view of Trump’s election promises such as lower taxation at the individual and corporate levels, and reduced regulation.
As expected, the interest rate cut on December 18 supported the index further. However, cool but sticky inflation and the Fed’s cautious stance about the rate cuts in 2025 dampened the mood. The S&P index ended December below the 6000 mark. Nevertheless, the index’s average was up 6.6 percent over the previous quarter. The y-o-y performance of Q4 was even more impressive. The index recorded 32 percent growth over 2023 Q4.
‘Goldilocks economy’ and euphoric sentiment
Currently, investors seem to have chosen to focus on the pros rather than cons of Trump’s policy agenda. Higher tariffs on imports would increase the costs for corporations that rely on imported intermediate goods. Tax cuts would increase consumer spending, but mass deportations are likely to reduce the labor supply, pushing wages higher.
Given the increased probability of higher inflation and tighter monetary policy in 2025, the stock market’s euphoria is not based on realistic fundamentals. Cutting taxes without cutting government spending would cause the budget deficit to grow. Bigger national debt and borrowing costs would impede the US economic growth. Although the economic growth is strong and the US unemployment is low, US companies are not as optimistic as consumers regarding the future earnings prospects.
As interest rate cuts continue, US households have increasingly allocated their savings to equities. Given that the semiconductor sector has been facing higher uncertainty from future trade wars and high tariffs, it is difficult to justify the current market optimism. The S&P 500’s growth in the last two years is a reminiscence of the dot-com bubble.
Trump’s administration’s pledge to end the war in Ukraine also contributes to the positive investor sentiment. It remains to be seen if the overvalued stock market can extend the gains to 2025. We anticipate some correction in the coming year, but we expect this to come later than Q1.
GDP Q3 growth is stronger than the early estimates
The United States’ Gross Domestic Product (GDP) expanded at an annual rate of 3.1% in 2024 Q3 according to the final estimate (Source: the Bureau of Economic Analysis (BEA)). This was an upward revision from the previous estimate of 2.8 percent. The upward revisions of exports and consumer spending were behind the higher GDP growth. The GDP growth in Q3 was higher than Q2’s 3 percent growth. Coupled with lower initial jobless claims, strong GDP growth caused a surge in Treasury yields.
The strong GDP growth was a shred of further evidence that US consumer spending is the engine of growth. So long as consumer spending which accounts for more than two-thirds of U.S. economic activity, stays healthy, the US economy is not expected to have a hard landing. Consumer spending is related to job creation. 227,000 jobs were created in November. This was well above October’s 36,000 and above the Dow Jones consensus forecast (216,000 jobs). US unemployment edged up to 4.2 percent from last month’s 4.1 percent.
Retail sales edge up, home sales continue to grow
Starting with the economic data, retail sales rose in November and home sales had a strong momentum:
The advance estimate of U.S. retail and food services sales for November was up 0.7 percent from the previous month (both seasonally and inflation-adjusted). This estimate was 3.8 percent (±0.5 percent) above November 2023.
The National Association of Realtors index of pending home sales increased 2.2 percent in November after rising 2 percent in October. The index was highest since February 2023. The Pending Home Sales Index leads existing home Sales by a month or two. The latest figure shows that the US housing market’s recovery continues its strong momentum after stalling in July. US home buyers are getting more optimistic about the prospect of lower mortgage rates with falling inflation.
No significant loosening in the labor market
In the week ending December 21, the advance figure for seasonally adjusted initial claims was 219,000, a decrease of 1,000 from the previous week’s unrevised level. The 4-week moving average was 226,500, an increase of 1,000 from the previous week’s unrevised average. The advance seasonally adjusted insured unemployment rate was 1.3 percent for the week ending December 14, an increase of 0.1 percentage point from the previous week’s unrevised rate.
The US unemployment edged up to 4.2 percent in December. Once again, the initial jobless claims are much lower than the critical 250,000 mark. The latest uptick in the unemployment rate signals that the labor market is slightly loosening.
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.
Inflation edges up again
The annual inflation rate in the US accelerated to 2.7 % in November 2024, compared to 2.6 % in October, in line with expectations.
The Federal Reserve’s preferred metric — the personal consumption expenditures price index increased to the annualized rate of 2.5 percent in November from 2.4 in October. This was slightly lower than the market analysts’ projection. Core inflation, which excludes food and energy, showed an annualized rate of 3.3 % in November, unchanged from October.
After December´s rate cut
As expected, the Fed announced a 25 bp rate cut on December 18. The Fed and the markets continue ruling out a hard landing for the US economy, especially after the upwardly revised GDP growth in Q3 and strong job creation in November. The inversion in the yield curve at the end of August disappeared and at the end of December, the difference between the 10-year and 2-year US Treasury Bond yield was positive (0.31). The figure is well above its value at the end of November (0.05).
The 10-year U.S. Treasury Bond yield ended December at 4.53, noticeably higher than November’s 4.18 percent. It seems that the euphoria after the presidential election has started to wane. The possible inflationary impact of Trump’s tariff policy, coupled with the strong GDP growth has discouraged investors from the likelihood of aggressive interest rate cuts.
We believe the Fed will evaluate the impact of the US tariffs in 2025 when/if the policy is implemented. If the policy is redeemed inflationary, the Fed may choose not to loosen its monetary policy in 2025. As things are seen, the policy interest rate may remain above 3.5 percent in 2025. One cannot foresee the impact on inflation as other factors such as energy prices are at play. If the war in Ukraine ends peacefully in early 2025, the final effect on US inflation may be less than feared.
US corporate earnings were stable in Q3
The US corporate earnings with inventory valuation and capital consumption adjustments (domestic industries) were stable in Q3, slightly edging up over Q2. The recovery owed to lower production costs, as a result of the cooling inflation. The earnings were up 0.8 percent from the previous quarter and 9.3 percent over 2023 Q3.
Our consumer sentiment indicators are based on our ‘keyword’ algorithm related to ‘Google Trends’. Accordingly, these indicators are among the explanatory variables that predict US corporate profits. Our prediction for 2024 Q4 is stable corporate earnings, with a 2.2 percent growth over Q3. We expect the earnings to be 5.7 percent higher over 2023 Q4.
The historical data from December 31st, 2024
The S&P 500 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).
For the fourth quarter, Factset estimates S&P 500 companies to report year-over-year growth in earnings of 11.9% and y-o-y growth in revenues of 4.6%. If their forecast is correct, this would mark the highest (y-o-y) earnings growth since 2021 Q4.
Market analysts believe that earnings growth outside of ‘Magnificient 7’ companies will significantly improve in 2025. They expect earnings growth for those companies to be around 13 percent in 2025. We believe these forecasts are on the optimistic side especially if sticky inflation gets in the way of further monetary policy loosening.
The graph below shows the S&P index forward P/E ratio, calculated using the monthly interpolated US company earnings and the S&P 500 index (indexed to 21 for June). As can be seen, the P/E ratios were also over 20 for long periods in the past. Although the forward P/E ratio is high by historical standards, we do not expect a sharp downward correction to come in 2025 Q1.
