2025 Financial Perspective: Stocks and Bonds Unveiled Beyond the Mirror
2025 Financial Perspective: Stocks and Bonds Unveiled Beyond the Mirror
Instead of the usual market predictions, filled with all the risks associated with prophecy, we'll embark on a journey similar to Alice's in Lewis Carroll's story, to discover some logic in markets that can at times seem illogical or irrational. Rather than gazing into a crystal ball, examining the current pricing in financial markets and determining its reasonableness could be more beneficial.
At the start of the year, the U.S. economy showed less promise, yet it surpassed expectations in 2024, with a growth rate anticipated to be around 3% by year's end. Though 2025 economic growth forecasts have improved, most experts expect a slowdown, approaching the U.S. economy's long-term growth potential of about 2%.
Examining last year's GDP estimation changes reveals their unreliability at the beginning of the year. Considering the various conflicting forces at play, it's essential to view these estimates with skepticism. Could the elimination of regulatory burdens under the Trump administration boost economic growth, or might the potential implementation of tariffs create a headwind? What external factors could potentially impact the economy?
After a strong performance, assigning a low-conviction level to the forecast for 2025 economic growth is prudent. The U.S. economy has momentum, but signs of labor market softness have emerged.
“If you don't know where you are going, any road will take you there.” – The Cheshire Cat
In light of moderating job growth and a firm monetary policy, the Federal Reserve reduced short-term interest rates in September. After the 0.25% rate reduction on December 18, the Fed has lowered short-term interest rates by 2%. Immediately following the meeting, Chair Powell suggested a pause in rate cuts to evaluate expected economic conditions in January. However, he also hinted at future rate reductions due to the tight monetary policy.
“Why sometimes I’ve believed as many as six impossible things before breakfast.” – The White Queen
A reasonable estimate for the fair value yield on the U.S. 10-year Treasury is its approximation of nominal GDP growth, which includes real GDP and inflation. After the 2009 global financial crisis, 10-year yields were consistently below fair value levels, but the Fed's tightening measures and improved economic conditions have brought them closer to their fair value levels.
With a 10-year Treasury yield around 4.6%, investors once again receive a fair compensation for taking on interest rate risk. With long-term inflation predicted to be around 2.3%, investors demand a 2.3% real return from the 10-year note. This 2.3% real expected return is slightly higher than the average from 1999 to 2008 but below the 2.1% median for the same period.
Although bonds do not appear excessively cheap, they offer a satisfactory risk/reward ratio and serve as an effective diversifier in the event of a stock market decline due to an economic downturn. With consumer inflation currently at 2.7% year-over-year, inflation is forecasted to decline over time. However, even if inflation remains steady, bonds should continue to provide a decent after-inflation return.
Switching our focus to U.S. stocks, the current market conditions reflect a positive yet challenging economic backdrop. This year, cyclical stocks, which are more sensitive to economic conditions, have outperformed less economically impacted defensive stocks. The S&P 500 expects earnings to increase by more than 12% in 2025, following a 9% expansion in 2024. With such favorable economic projections already reflected in the market, investing in underperforming defensive sectors like consumer staples and healthcare seems like a wise move for 2025. However, it's important to acknowledge that attaining these growth figures might be difficult.
“It would be so nice if something made sense for a change.” – Alice's statement in Wonderland
Interestingly, higher stock valuations appear more plausible than may initially seem. A 22-times multiple of next year's estimated earnings, also known as the forward price-to-earnings ratio, suggests stocks are not particularly cheap relative to historical standards. However, historically, the price-to-earnings ratio (P/E) is correlated with return-on-equity (ROE), which measures how efficiently companies produce profits from the shareholder capital. Though ROE is below its recent peaks, it remains above average and argues for an above-average P/E ratio, assuming this improved ROE is sustainable. Consensus estimates indicate that ROE will rise to 19% in 2025, up from 17.8% in 2024. To provide some context, the S&P 500's ROE was 15.1% in 2019 before the pandemic.
The impressive return on equity, as previously mentioned, and contributing to high stock valuations, is accompanied by elevated profit margins compared to historical norms. Profit margins signify the proportion of revenue that transforms into profit. For a business proprietor, higher profit margins, keeping other factors constant, are more valuable. Notably, the tech sector's profit margins are nearly twice the industry average. Moreover, tech sector earnings are anticipated to expand at approximately twice the speed of the S&P 500 this year and are projected to rise around 20%, surpassing the S&P 500 once more next year. This fusion of superior growth and profitability is responsible for the tech sector's surge by 39% this year, contributing to the S&P 500's roughly 29% overall return year-to-date.
As Warren Buffet puts it, "The worth of a business lies in the cash it's expected to generate in the future, discounted to the present." Free cash flow represents the cash remaining after a corporation meets operational expenses and invests in its business. Essentially, it serves as a yardstick for the cash returned to shareholders as owners.
Free cash flow yield is calculated by dividing free cash flow by the stock price. Similar to price-to-earnings, cash flow yield suggests a market that is far from being low-priced, albeit it has been more pricey at certain points in the past. This indication assumes that free cash flow remains consistent, implying that investors are optimistic that free cash flow will continue to expand. Investors are typically willing to pay more for a company with a high degree of certainty that the corporate profits accruing to shareholders will persistently increase.
As a subset of the S&P 500, tech stocks are less expensive in terms of free cash flow yield. This premium valuation stemming from the faith in these companies' futures and the sector's exceptional fundamentals in the past. The impressive profit margins and growth rate of the tech sector have accounted for the high valuation assigned by the reduced free cash flow yield.
Curiouser and curiouser! – The Mad Hatter
According to Warren Buffet, "Interest rates are akin to gravity in valuations. If interest rates are nil, values can be almost limitless. If interest rates are high, that's a substantial gravitational pull on values." While bond yields have surpassed pandemic lows, valuations have yet to be negatively impacted by this rise. This prolonged appraisal hike could be due to countering the gravitational pull through better profitability, growing optimism towards artificial intelligence, and economic resilience.
All is well that ends well – William Shakespeare
Historically, there have been few instances of consecutive years with over 20% annual returns, as we anticipate for 2023 and 2024. The 1935 to 1936 period saw a robust rally followed by a significant 39% decline in 1937. The 1954 and 1955 bull market resulted in a subpar year in 1956, then a 14% decline in 1957. The aggressive 1995 to 1999 rally, often referred to as the tech bubble, experienced three straight years of declines from 2000 to 2002.
These historical lessons convey three main insights. Initially, these escalations can persist longer than anticipated. The tech bubble, fueled by the internet and e-commerce promise, is a prime example. Although the internet revolutionized the world, valuations became excessively high. Today's technology titans are robust businesses and appear to be benefiting from the next significant development – artificial intelligence. Consequently, it is not a given that they will decline or falter in the coming years. Secondly, these positive results bring us closer to uncharted territory, which could lead to a more volatile market in 2025. Lastly, despite the pain accompanied by market declines, stocks have always recovered (eventually) and have provided the most impressive return among all asset classes in the long-term.
Bond yields seem to be suitable compensation for the risk that inflation might rise or fail to subside. At current levels, bonds should be capable once more of proving their historical purpose, which is income generation and portfolio diversification during a sharp stock market downturn.
Stocks are valued based on an optimistic economic outlook and the Federal Reserve's ongoing support. Moreover, enhanced corporate profitability and double-digit earnings growth may be necessary to maintain elevated valuations. While this scenario is plausible, if not the most probable, investors should recognize that the hurdles at these valuation levels are formidable. Diversification in stock portfolios is suggested, with healthcare and consumer staples offering potential alternatives, particularly if the economy underperforms or the artificial intelligence trend encounters turbulence.
As 2025 approaches, investors are encouraged to reassess their risk tolerance since the robust two-year stock rally has likely expanded their holdings in risk assets. Rebalancing stock and bond allocations towards the target risk level is wise for many investors, particularly as the new tax year commences. The secret to successful long-term stock investing is maintaining investment during challenging times and then reaping substantial and unpredictable rebounds by not divesting during bear markets. Maintaining enough investment in stable or income-generating assets can provide enough comfort to weather market turmoil without selling stocks unnecessarily.
- Despite chair Powell's hint at future rate reductions, the Federal Reserve's monetary policy is firm, which could pose a risk to stock market investors looking forward to the 2025 outlook.
- In light of the improved 2025 economic growth forecasts and signs of labor market softness, investors might consider diversifying their portfolios, moving some funds from technology stocks to sectors like consumer staples and healthcare.
- The bull market of 2023 and 2024 has seen stocks achieve over 20% annual returns, but history has shown that such escalations can persist longer than expected, leading to more volatile markets in the future.
- Although bond yields have surpassed pandemic lows, investors should keep an eye on the potential impact on stock valuations, a factor that Warren Buffet identifies as having significant gravitational pull.
- Examining the current stock market conditions, bond yields, and economic growth forecasts, investors should expect a challenging yet positive market scenario, asking themselves important questions about their risk tolerance and investment strategies for the coming years, up to 2025.