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The beginning of a new year is a great opportunity to set resolutions. After reviewing over 30 market commentaries in the past few weeks and analyzing how long readers spend on my previous pieces, one of my resolutions for 2025 is to write more engaging market commentaries than I did in 2024. To achieve this, I’m changing the format of my first commentary of the year and will share my ten predictions for the markets in 2025. At the end of the year, I’ll revisit these predictions to assess their accuracy. Having studied market commentaries and their predictions for a decade, I believe that I will be satisfied if six out of ten of these predictions come true. However, I also recognize that the central theme of 2025 might end up being something entirely unexpected. So, without further ado, here are my ten predictions for 2025. |
1. Small Caps Outperform Large Caps This is one of my higher conviction calls. Small-cap stocks have underperformed large-cap stocks by 91% over the last ten years. That has only happened four times in history, and all four were followed by small cap outperformance over the next 3- and 5-year horizons. Current earnings per share growth estimates for the next two years are +18% for small caps to +10% for large caps. Finally, large caps are trading at 17.2x 2025 earnings vs 13.6x for small caps. So, to sum it up, small caps are cheaper, with higher expected earnings growth, coming off a period of historic underperformance. 2. We have at least a 10% correction in the S&P 500. This is probably the least bold of all of my calls. The S&P 500 averages a 10% correction every 1.2 years and we didn’t have one in 2024. Given the fact that the S&P is coming off of back-to-back 20%+ years as well as at a higher-than-average valuation historically, the probability of a 10% correction or more is relatively high. There is also the possibility of a lot of headline risk. Tariffs figure to be in the headlines a lot in 2025, with both threats of tariffs from the US and threats of retaliatory tariffs from other countries likely to cause some market jitters. While we view tariffs as a negative for markets, we do think President Trump views tariffs as a negotiating tactic, and so the selloffs on headlines of threat may well be worse than what gets enacted. 3. The Fed cuts more than the current market estimate of two times. This is a very challenging one to predict. Two months ago, the market was forecasting four cuts by the Federal Reserve in 2025, but stickier inflation data and slightly improving unemployment data have caused the Fed and markets to adjust course. We think inflation data will continue to improve (more on that later) and we may see continuing weakness in the labor data with the continuance of trends from 2024. There is also the possibility of an additional rise in unemployment through both automation of jobs by AI, and DOGE (Department of Government Efficiency) public sector intervention (as their role is to cut spending, which will likely result in layoffs of some government jobs). Overall, we view the economy as slightly weaker than is the current consensus, and while the pendulum has currently swung towards fewer Fed cuts being necessary, we think that pendulum will swing back as more data comes in during the first half of 2025. 4. Magnificent 7 dominance slows, and the equal-weighted index outperforms the market weight index. Stocks go up for two reasons: 1. Because earnings are growing or 2. Because they are getting more expensive based on expectations of future earnings. In 2024, the Magnificent 7 stocks (AAPL, MSFT, GOOGL, AMZN, NVDA, META, and TSLA) outperformed the other 493 stocks in the S&P in terms of price by 43%, while earnings of the Mag 7 outperformed earnings of the other 493 by 29%. This has been the theme for the last few years, with Mag 7 outperformance in price driven mainly by outperformance in earnings, with the remaining amount driven by the expectation of future earnings continuing to maintain the relative advantage. In 2025, earnings for the Mag 7 stocks are only expected to grow by 7% more than the rest of the S&P, and that margin is expected to shrink further in 2026. Earnings growth is still positive for the Mag 7 stocks, and we are not bearish on the group (meaning we don’t think they’re going to experience a long term downward trajectory), but when the growth is more in line with the rest of the S&P, we think the case for owning a disproportionate percentage of them compared to the rest of the S&P weakens. We think that a scenario where earnings growth remains strong, but the return leaders for the S&P 500 in 2025 are stocks outside of the Mag 7, would be very healthy. 5. Inflation finishes the year lower than it starts but is still short of achieving the Fed’s 2% target. CPI is currently sitting at 2.75%, down significantly from the high of 9% in 2022, but has stayed in this range without making much further progress for the last six months. We see some improvement, likely in the inflation rate, as rentals should slow down, and freight rates should contribute to softer consumer goods prices. However, we do not see enough data to forecast a fall in inflation to the Fed’s 2% mandate, which will leave the Fed in a challenging position. 6. Financials outperform technology for the second year in a row. Most people might not realize this, but the financial sector outperformed the technology sector in 2024 by about 1%. Much of this relative outperformance came after Trump won the election with a runup, particularly in regional banks, on hopes for deregulation and an increase in M&A (mergers and acquisitions) activity. We believe those themes should continue in 2025, along with regional banks benefitting from Fed cuts and more capital market activity across the board, which could help the financial sector. We are not bearish on the technology sector. Still, it has been carried a lot by a few names recently, and we see the momentum of the rally fading, which is reasonable with historically high valuations for the sector. 7. Emerging markets outperform the US for the second time in the last 8 years. It’s no secret that emerging markets have underperformed the US for the last 15 years. It’s also no secret that emerging markets are valued much more reasonably than their US counterparts (EM trades at 13x earnings while the S&P 500 trades at 27x). However, many of us have pointed that out for years, and the US has continued to outperform. There’s always a good reason not to invest in emerging markets, including some recent ones like underperformance vs. the US recently, the risk of US tariffs on China, and the risk of a stronger dollar’s effect on local emerging market currencies. One factor that isn’t discussed much is the sector’s effect on emerging markets vs the US market. The S&P 500 is highly concentrated in technology stocks, whereas emerging markets have a much higher allocation in financial stocks than the US. We believe that financials will outperform, which could potentially help emerging markets relative to the US. We view the dollar as more likely to be weaker than the current market consensus due to less tariff follow-through and more Federal Reserve cuts, which should boost financial markets. We also think that while the Chinese economy certainly has a lot to work through, there is an overly negative scenario currently priced into the market, and whether through the loosening of financial conditions or payoff from investments in AI, we think the Chinese stock market could positively surprise us compared to expectations. Finally, when people focus on the last 15 years of relative performance between the US and emerging markets, they forget that in the decade prior to that, emerging markets beat the US by an average of 9% per year! This is a call we’ve made before and been wrong, so one of these years, it will finally prove correct! 8. The US avoids a recession in 2025. The consensus right now is that the US will avoid a recession in 2025, and we agree, but we do think economic conditions will worsen moderately, and we may end 2025 talking more about a recession than we are currently. The housing market is frozen with no immediate path to improvement as high interest rates keep homebuilders from being able to fix the supply issue. Additionally, we think the labor market may weaken, and while we don’t see that moving into recession territory, we think it will be a growing concern as the year goes on. Earnings continue to grow, albeit at a slowing pace, and we think deregulation and increased M&A activity will be positives for certain sectors, such as financials. Overall, our view is that we will see a slowing economy that ends the year with increased recession risk but does not tip into recession territory and is quite favorable for specific sectors! 9. The S&P 500 finishes positive for a third straight year but with a more prolonged correction and lower returns than the last two years. Having back-to-back 20%+ returns for the S&P 500 like we did in 2023 and 2024 has only happened five other times since 1871. The average return in the year after has been historically lower than average, with only two of the five being positive. Uniquely, the 3-year returns for this stretch compared to the other five are much lower, and if you look at the duration of those rallies, it suggests we may still have some time left in this rally, but the point still stands that we probably should not get used to returns like we have seen the last two years. We are also coming off a time of decreased volatility with smaller corrections than are normal, and with the current economic setup and the potential for trade disputes and interest rate volatility, it is likely that we may see a choppier year in equity markets in 2025. 10. The US 10-year treasury finishes the year lower than it starts, and the aggregate bond index has its best year for returns since 2020. This is a bit of a non-consensus view, as bonds are out of favor at the moment. Our view of lower rates is driven by the fact that we think the Fed will cut more than expected due to improving inflation data and worsening labor market data. It’s also driven by the fact that while no one is great at predicting interest, we have noticed that often, when the pendulum of consensus on interest rates swings hard in one direction or another, it is typically wrong. Currently, the pendulum has swung hard towards higher rates, with many adjusting their expectations downwards for Fed cuts and upwards for interest rate levels. We’ve seen this overreaction to a few comments by the Fed enough times to think that it’s likely that there will be a course correction in consensus shortly. If you made it this far, you’ve likely read a mix of predictions that will come true alongside some that won’t. I hope when I revisit these a year from now, they will be more accurate than not, but I remember too well the dozens of confident market predictions in previous years that were all wiped out by March thanks to an event no one saw coming, to have too much confidence in any of my predictions. If you have questions about the positioning of our portfolios considering these views, I’m more than happy to go into more detail about our allocation decisions. Christian |
