1Q25 Market Outlook: The Market Rally Continues, but High Valuations Temper Its Rise

John P. Swift, CFA, CPA Chief Investment Officer
312-259-9595 or [email protected]

Let the Good Times Roll

The S&P 500 could continue its unprecedented rally this year on a combination of AI-infused growth and deregulation. Still, investors will be more cautious as the reality of already high valuations and executing the Trump economic agenda of lower taxes and deregulation will be more complex than expected.

2024 in Perspective: A Tremendous Year Despite World Concerns

The stock market enjoyed another tremendous year despite continuing geopolitical conflict in Ukraine/Russia and the Middle East, a faltering Chinese economy, stagnant growth in Europe, and rising U.S. interest rates despite the reduction in the Federal Funds Rate.

The higher interest rates reflected inflation fears and spiraling U.S. deficits. Still, these rates also reflected the surprising resilience of the U.S. economy and the realization that we are not headed for recession. The fears of recession, which we have been arguing against since 2022, were finally swept away by resilient economic data and strong corporate earnings results during the year. The Fed pivoted in 2024 and began lowering interest rates as improvements in inflation became clear. This recession fear was ultimately replaced by optimism that the U.S. economy would enjoy either a soft or no landing at all, and the election of President Trump to a second term coupled with tight majorities in the House and Senate sparked optimism of lower tax rates and deregulation.

Artificial Intelligence and its enablers across a broad spectrum of mega-cap technology stocks were the underpinnings of the solid performance for most of the year except for a minor hiccup in the summer in the wake of earnings results from Nvidia and Alphabet that, while strong, did not live up to the market’s lofty expectations set for these firms. This proved to be nothing more than a brief buying opportunity as the mega-cap technology stocks, led by the Magnificent 7 (Nvidia, Microsoft, Apple, Amazon, Tesla, Alphabet (Google) & Meta Platforms (Facebook), powered the continued upward trajectory of the market in 2024.

Looking at 2025

The stock market is counting on a lot of good things happening, such as:

• Reduced regulations
• Extension of the 2017 tax cuts
• Continued reduction of the Federal Funds Rate
• Strong Corporate Earnings Growth

On this last point, we are forecasting 15% corporate earnings growth in 2025 and a slight pullback from the beginning valuations based on less optimistic growth expectations and the reality of how hard it is to get anything done in Washington DC, even with tight Republican majorities in the House and Senate.

The S&P 500 ended the year priced at 21.9 times the forward one-year earnings expectation, a 20% premium to the 10-year average. We believe this price multiple will pull back to the upper 20’s, and overall, we expect the S&P 500 to increase in the 9-11% range in 2025.

It’s All in the Execution

Since the market has a lot of good expectations heading into 2025, execution is key, and each earnings and economic report will be parsed and debated. Nothing can upset the fundamental view, as most portfolio managers are positioned for mostly good news. It is as if the market thinks that the glass is half-full, and the glass is expected to be brimming by year-end.

Now, if something happens to knock down earnings expectations, perish the thought; there will be a meaningful correction in the market. However, the market can undoubtedly support these valuation levels if things stay on track. This is why earnings reports, economic data, the Fed’s monetary moves, the deficit, and Washington DC will be closely monitored. There is much to be optimistic about but not much room for error.

If Artificial Intelligence can boost earnings, growth could make today’s valuations look inexpensive. Moreover, valuation is a lousy timing tool. While high or low valuations can be predictive over long periods, they have little correlation to the market’s performance over the next year. However, high valuations are uncomfortable for investors, and volatility usually rises when valuations are at a high premium to the 10-year averages.

Sector Weights

We will remain overweight in economically sensitive sectors such as consumer cyclicals and financials while remaining underweight in defensive sectors such as healthcare, utilities, and telecommunications. However, our biggest overweight will remain Big Tech, which offers the best combination of growth, quality, and safety in 2025. They are the primary beneficiaries of the AI boom. Their earnings growth remains well above the market averages. They have defensive characteristics in their best-in-class balance sheets and can pass along price increases that extend their attractive profit margins.

Elon Musk & the Department of Government Efficiency (DOGE)

The Tesla (TSLA) CEO, Elon Musk, and venture capitalist Vivek Ramaswamy will lead the efforts of DOGE, a new nongovernmental agency, to wring out $2 trillion in governmental spending through 2028. Musk is legendary for his hatred of bureaucracy, and they are quickly learning to hate him back.

It will be a great theatre, to be sure, and I find an interesting parallel with WW2 history. In 1940 when Winston Churchill became Prime Minister during the darkest days of the Nazi push through Europe, Churchill called upon his friend, Lord Beaverbrook, to increase the production of planes that would enable the Royal Air Force (RAF) to provide for an effective defensive and ultimately offensive capability.

The problem was that Lord Beaverbrook didn’t know the first thing about building planes. He had built his fortune on selling newspapers, but Beaverbrook shared a significant characteristic with Musk, they both vehemently despise bureaucracy. Beaverbrook quadrupled airplane production and became an enemy of the English government bureaucracy. Beaverbrook didn’t care and, through his initiatives, saved England from capitulation and surrender to the Nazis.

Will Musk cut over $2 trillion in governmental expenses? Probably not, but I’m betting that Elon “Beaverbrook” Musk and his DOGE partner, Vivek Ramaswamy, will find more efficient ways of getting things done in Washington DC, save billions in waste, and change the course of many governmental agencies for years to come. And in the process become persona non grata among the DC bureaucracy. Now, sit back and enjoy the show unless you are a federal government employee, in which case, fight like hell!

Good luck to all, and I wish you another successful year with your families and finances.

 Warm regards,
John P. Swift, CFA, CPA