Investment Insights

 — Steve Orr 

Hangover 

In a bygone era, folks would party to celebrate the New Year. How long one took to recover indicated the level of fun one experienced. Or so we were told. Mr. Market’s hangover this year reminds us of a bigger hangover in 2018. The cocktail was the same: Stocks wanting to hold gains, the possibility that the Fed would lower rates and a slowing global economy. In mid-December 2018, Fed Chairman Powell declared that more rate increases were in store. The S&P 500 was holding on to a tenuous 5% gain for the year until Mr. Powell took the podium. Taking away the punch bowl of lower rates pushed the big index to a loss of 9% that December.

Flash forward to 2024. Thanks to the artificial AI boom and a 1% cut in short-term rates by the Fed, the S&P 500 entered December with a 28% gain. In his December 18 press conference, Powell indicated that fewer rate cuts were likely in the coming year. Traders and fast money types promptly turned risk off, pulling the big index down to 2.4% loss for the month. And so much for our beloved Santa Rally: From Christmas Eve through year-end, the S&P declined 2.8%. That is easily its worst decline for a year-end that we can remember. Another Powell Punch to sour markets for the New Year. Markets like two things: certainty and low interest rates.

Up next

The 2025 return of President Trump to the White House has ramped up uncertainty. Traders had been counting on lower interest rates to revive housing and mortgage trading. After December’s job report, they may well wait through all of 2025. The Bureau of Labor Statistics estimated that non-farm payrolls rose 256,000 last month. Like much of 2024, the gains were in government and education hiring. Government hiring grew at a near-4% rate last year, or almost double the inflation rate. Manufacturing hiring has barely budged, and private payrolls have grown less than 2%. The household survey showed the unemployment rate dipped by a tenth to 4.1%.

Government hiring and spending during the last administration, combined with easy monetary conditions, have kept the economy in a moderate, second-gear, growth mode. Tariffs are a popular worry about the incoming administration. We would direct your attention to maintaining the 2017 tax cuts (which the media calls “more tax cuts”), deregulation (disinflationary) and lower spending. All three must go through Congress. If spending is cut before regulations are cut, we may find ourselves with a rapidly slowing economy.

November’s and December’s 256,000 gains may include hurricane-related recovery from October’s low 43,000 job gain. December and January job reports usually have some seasonal adjustments and revisions. If the December job gains hold, then the rolling six-month average gain of 112,000 per month would represent a steady, second-gear economy that does not need rate cuts.

This week’s consumer price index report is up next. We expect the headline to rise 0.2% back to 2.9%. We were pushing the idea last summer that inflation was bottoming and heading higher. This is one forecast we would like to get wrong. September’s 2.4% was likely the cycle low for inflation. 
 

2025 Outlook

Economy

If inflation is not going away, what effect will that have on the economy? Purchasing power, as measured by real average hourly earnings, will continue to struggle to keep up. The economy reset after shutdowns and the duration of the business cycle appear to have shortened in our view.

GDP growth in the final quarter of 2024 will likely come in around 2.4%. The Atlanta Fed’s GDPNow tracker estimates first quarter 2025 growth at 2.7%. Those levels would mean the economy averaged 2.7% growth over five quarters. Again, “second gear” in our thinking, or Goldilocks if you prefer. Not so Hot would be the second half of 2025.

We think there is a moderate-to-strong likelihood that the economy will slow later this year.
Drivers of our thinking:

Earnings 

A slowing economy means fewer opportunities to grow earnings. Nearly half of the S&P 500 earnings come from overseas, so a “too strong” dollar can affect sales. We have stayed bullish on stocks since the beginning of the current bull cycle. We continue to follow our indicator dashboard, trusting our instruments over market emotions. Earnings growth has accelerated over the past three years. Almost all sectors have participated. Energy is the outlier, with earnings largely dictated by swings in oil prices.

Wall Street consensus, ever the optimistic lot, believes earnings will grow 14.8% (FactSet) or 14.2% (S&P, Yardeni). Check the graph below — you can see how as earnings estimates get revised lower as companies report and the Street adjusts its forecasts.
 

Note the red line for 2025 has yet to come down. Be patient. How about a historical approach? In year three of Bull cycles, both price and earnings growth slow. The typical gain for this point in a cycle is around 6%. Let’s add in 1% for a slowdown from 2% in share repurchases and an additional 2% for excitement over Congress renewing tax cuts early in the year. That would put 2025 EPS growth at a healthy 9%. Yes, it’s a big drop down from current Street forecasts. 

2024’s earnings may finish on a high note as those same Wall Streeters forecast fourth quarter earnings growth of 11.7% (FactSet). That would be the highest year-over-year growth since 2021. And that would be fine by us, because companies usually beat estimates. According to FactSet, the actual earnings growth rate has exceeded estimates by the end of the quarter in 37 of the past 40 quarters. Over the past five years, actual earnings have beat estimates by 8.5% and 77% of companies in the S&P 500 have beat .

The fourth quarter season ramps up this Wednesday with the big banks: JP Morgan, Citi, Wells and Goldman Sachs. Six of the Magnificent 7 report the last three days of January. Earnings reporting season lasts about seven weeks, and we have a good idea of where we will end up by the third week.

Stocks

We are not given to forecasting, as we have plenty of other ways to look bad. If S&P 500 earnings grow at 15% over a $245-ish earnings per share, that would put year-end 2025 earnings at $281. Using the (high) 22 times Price/Earnings multiple of today gives an index value of 6,200, or a roughly 7% return from today’s level. Our “historical” 9% earnings growth would produce $267 in earnings per share and at 22x, an S&P 500 level of 5,875. That would be a 1% return, a bit low for this stage of the Bull cycle (sarcasm alert).

How about some positive and minus events and trends that could push earnings? Here are some of our thoughts:

Rates

Markets of all stripes waited through most of 2024 for the Fed to start cutting short-term rates. Since September 18, the Fed has cut its overnight Fed Funds range by a full 1%. In contrast, Treasury yields started climbing that day. As of this writing, longer-term interest rates have risen over 1.25%. What gives? The outgoing administration continues to “dump” dollars on the economy, spending on programs and grants, trying to drain the Treasury. Traders rightly fear continued spending and future inflation from three years of deficits that are 5% or more of GDP each year.

The 10-year Treasury Note closed last Friday at 4.75%, and from a technician’s perspective, it has the momentum to rise higher. In October 2023 and April 2024, longer-term rates ran to and through this level. Both times stocks went through a correction, shedding 6% to 10% from their recent highs. Both lasted less than three months. There are echoes of those periods today: Fed indecisiveness, Congress stagnant, sticky inflation worries.

We see two positives over the next several months that should stall the rate rise and may even cause rates to drop. First, the debt ceiling was reached on January 1. Until Congress passes a higher debt ceiling, no new Treasury debt can be issued. Second, deregulation efforts by the new administration should be deflationary and may cause spending to either slow or be redirected into more economically efficient areas.

So good 

It’s bad again. Stocks and bonds both sold off last Friday after the strong December jobs report. Some of the selling appeared to be “long longs” — traders who have held profits well past their long-term capital gain threshold. The new year is a good time to “take out the trash” in portfolios. We note that January and February job reports tend to have low response rates and seasonal adjustments in the spring. Do not be surprised if this jobs number is not quite as strong as the first print. Consumer inflation and industrial production numbers later this week should support the job report that our economy remains in second gear.

Regardless, the Fed has little reason to cut in the next six months, and that worry drove some fast money to cut bait. The stock Bull cycle has room to run, and long-term support is still intact. Internals, especially the percent of stocks making new lows and below their 20-day moving average, were actually worse a week or two ago. This suggests that we are near a trading low, and a bottoming process may be developing. The intermediate trend is your friend, and all our indicators remain green.