If I had to use a single word, to sum up 2024, it would be “unlikely”.
At the start of the year, few would have predicted the twists and turns of the presidential election (Biden’s debate performance and subsequent decision not to run, Trump’s attempted assassination, the red wave, etc). Equally as unlikely was the stock market’s amazing year. This chart shows Wall Street analysts' 2024 Year-end Price Targets for the S&P 500. As you can see, the S&P 500 is currently on pace to finish the year 23% above the average target price and more than 10% above the most optimistic year-end target.
The stock market’s performance is all the more unlikely given that interest rates remained relatively higher than expected. Rate cuts were expected to begin in the Spring of 2024, but didn’t occur until September. The consensus view going into 2024 was that rates would decline to around 4% by the end of the year and 3.5% by the end of 2025. Rates are expected to finish the year about half a percent higher than the consensus view coming into the year.
We entered 2024 carefully watching to see if corporate earnings would slow and the Goldilocks economy would eventually sputter. However, inflation remained subdued, the unemployment rate remained low and consumers happily spent money in 2024. Geopolitical events didn’t escalate. Elections weren’t contested. Riots didn’t happen. In other words, the Goldilocks environment (see February 2024 blog) remained in place throughout the year; a scenario that seemed pretty unlikely 12 months ago.
What about 2025?
The stock market’s impressive performance in 2024 can be broken into two components: an increase in corporate profits (+9.5% estimated profit growth for the S&P500 in 2024) and an increase in the willingness of investors to pay more for those earnings from the previous year (+16.5% increase in price paid per dollar of earnings). Stocks don’t rise and fall solely due to increases or decreases in corporate earnings. Stock prices change daily due to changing expectations about the economy, the political environment, company performance, consumer spending, geopolitical events, and a litany of other considerations. Those changes in expectations lead to price changes in the short term.
There is a ratio that is used to measure the price that investors pay relative to a dollar of corporate earnings known as “Price to Earnings Ratio” or P/E ratio. A stock with a P/E ratio of 20 tells us that investors are paying $20 per dollar of corporate earnings over the previous 12 months. The current P/E ratio of the S&P 500 is approximately 26. That’s high by historical comparison.
What is “normal” for investors to pay per dollar of corporate earnings? The average P/E ratio for the S&P500 over the previous 30 years is 16.73 according to JP Morgan. If corporate earnings remain unchanged in 2025 and P/E ratios revert to “normal”, then the S&P 500 would decline by approximately 35%. Thankfully, we think that is an unlikely scenario.
Analysts expect corporate earnings to rise by more than 10% in 2025. The unknown input is the price investors will be willing to pay for those earnings by year-end 2025. Assuming some reversion to the mean, it’s feasible that the P/E ratio could decrease and create annual performance similar to what we saw in the 1991-1993 range (see chart above) or the 2004-2006 timeframe. In those instances, corporate earnings were reasonably strong, but investors began paying less per dollar of earnings. Should 2025 follow the same path, the stock market returns (as measured by the S&P 500 in the middle column of the chart above) would be “muted”, but tolerable. A more optimistic comparison could be 1999; a year in which corporate earnings were strong and the P/E ratio remained high by historical standards despite being elevated coming into the year. If investor optimism persists throughout the year, and the P/E ratio remains elevated, then the stock market could still provide some pretty appealing returns in 2025.
As always, we sincerely appreciate your continued confidence and trust. Please feel free to reach out with concerns and questions about your portfolio. We wish you all a Merry Christmas and a fruitful 2025!
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