Assessing US Equities in 2025: Fundamentals, Momentum, and Policy

January 21, 2025
Assessing US Equities in 2025: Fundamentals, Momentum, and Policy

As the financial world peers into 2025, investors cannot help but reflect on the remarkable performance of US equities in the previous year. The landscape in 2024 was one of robust earnings growth, the anticipation of a ‘soft landing’ following the Federal Reserve’s easing cycle, and optimism surrounding Trump’s return to office. These elements drove the S&P 500 to a striking return of 38.16% in Australian dollar terms, pushing the price-to-earnings (P/E) ratio to nearly 28x, a figure well above historical norms. While the market conditions were favorable for short-term gains, the high valuations prompt a need for caution as investors consider future returns.

US Equities in 2024: A Standout Performance

The stellar performance of the S&P 500 in 2024 has set a high benchmark, causing a ripple effect of anticipation and caution among investors. With the P/E ratio nearing 28x, a number that significantly surpasses historical averages, there is a looming question about the sustainability of such high valuations. The surge in the market was fueled by several contributing factors, including the buoyant earnings growth that the majority of US companies exhibited. Furthermore, the Federal Reserve’s easing cycle seemed poised to orchestrate a soft landing, an outcome highly anticipated by the market and investors alike.

However, this boost in market confidence, triggered partly by Trump’s return to office, has led to multiple expansions across the board, setting a high bar for 2025. Despite the highs of 2024, extended valuation levels now present a fundamental challenge for long-term investors. The equity risk premium, which compares earnings yields to government bond yields, turning negative, brings to light the limited risk-return tradeoff for US equities in comparison to safer bonds. As we pivot into 2025, investors will need to prioritize entry points that offer a ‘margin of safety’ to buffer against potential downturns in the market.

Assessing Fundamentals

The key to navigating US equities in 2025 lies in a firm grasp of fundamentals, specifically earnings momentum over price momentum. In 2024, the market was heavily influenced by momentum, with the MSCI USA Momentum index outperforming the MSCI USA index by over 700 basis points (bps). Despite this impressive showing, there is an undercurrent of concern as the broad market’s headline earnings estimates have witnessed a -2% decline in the past six months. This weakening, driven by factors outside the ‘Magnificent Seven,’ highlights the importance of earnings momentum for future market stability.

An intriguing divergence emerged in 2024 where the ‘Magnificent Seven’ stocks saw a significant 27% rise in their earnings estimates, juxtaposed against a -4% downgrade for the remaining 493 companies in the S&P 500. This gap underscores the necessity for investors to focus on the fundamental strength of earnings rather than being swayed purely by price movements. The reliance on robust earnings growth, positive revisions, and forward guidance will be crucial as the market continues to navigate unpredictable macroeconomic factors. As earnings momentum becomes a focal point, investors must be discerning, ensuring their portfolios are aligned with companies demonstrating solid and sustainable earnings growth.

Economic Momentum and Bond Yield Insights

The US economy’s capacity to maintain its momentum through 2025 is a critical factor for investors to monitor. Indicators such as the ISM Manufacturing and Services Activity figures have shown robust activity; however, challenges persist. The US 10-year government bond yield has climbed to 4.70%, reflecting economic confidence but also signaling caution as service inflation remains stubbornly high, and the labor market remains tight. Wage growth has slowed, indicating some relief, but the overall economic momentum is fraught with complexity and potential vulnerabilities.

The Federal Reserve’s fiscal stance has further added to the economic unpredictability. Initially, the Fed’s dot plot indicated a reduction in projected rate cuts from four to two 25bps adjustments. Yet, the real possibility of no cuts in 2025 looms, injecting more uncertainty into the market. Additionally, recent job openings data revealed a surprising increase, driven mostly by temporary part-time employment. This uptick raises concerns as sectoral declines in retail, manufacturing, and leisure/hospitality could exacerbate vulnerabilities, particularly in industries that only marginally reported growth, as per the ISM Services Index. The dynamic interplay between these economic indicators will significantly influence investor sentiment and market performance moving forward.

Fiscal Landscape and Policy

High debt levels are poised to significantly influence fiscal policy and, by extension, US equities in 2025. The constraints on fiscal policy due to mounting debt are likely to limit the government’s ability to implement expansive economic stimulus measures. This environment of high debt restricts flexibility, increasing sensitivity to changes in monetary policy. As a result, investors must be prepared for a climate of heightened fiscal conservatism that could impact market liquidity and overall economic performance.

The drastic fiscal shift anticipated between January 2023 and July 2026 is a testament to the evolving landscape. Initial baseline fiscal spending projections estimated around $500 billion; however, revised expectations suggest this figure could soar to $2 trillion by 2026. Such projections are largely driven by policy changes advocated by influential figures like Elon Musk and Vivek Ramaswamy. This enormous fiscal shift underscores the challenges traditional austerity measures face in the political sphere, highlighting the unpredictable fiscal environment investors must navigate. Consequently, careful and selective investment choices are imperative in light of these uncertainties. A strategy focused on robust fundamentals and quality earnings will prove essential amidst the fluctuating fiscal policies and their broader economic implications.

Strategic Takeaways and Investment Approach

The elevated valuations combined with stalled earnings momentum present a challenging landscape for investors targeting US equities in 2025. Therefore, a shift in investment strategy is warranted, prioritizing earnings fundamentals over price momentum. The market’s inherent volatility and the unpredictable macroeconomic backdrop make it essential for investors to anchor their decisions on robust earnings momentum. Key elements to watch include earnings growth, positive earnings revisions, and forward-guidance metrics from companies. These factors will provide clearer pathways through which investors can navigate the equities landscape effectively.

In addition, a diversified yet focused investment approach can help mitigate risks while capitalizing on potential upside opportunities. Selecting companies or funds that exhibit strong and sustainable earnings momentum will be pivotal in securing long-term returns. Investors may benefit from leveraging specific ETFs designed around fundamental analysis, ensuring that their portfolios are well-positioned to weather economic fluctuations and capitalize on growth opportunities.

Recommended Investment Tools

As the financial world sets its sights on 2025, investors reflect on the exceptional performance of U.S. equities in 2024. The year was characterized by strong earnings growth, hopes for a ‘soft landing’ following the Federal Reserve’s easing cycle, and enthusiasm about Trump’s re-election. These factors propelled the S&P 500 to an impressive return of 38.16% in Australian dollar terms, elevating the price-to-earnings (P/E) ratio to nearly 28x, a level significantly above historical averages. While market conditions in 2024 were favorable for short-term profits, the elevated valuations raise a cautionary flag as investors look ahead and ponder future returns. The unprecedented surge in stock prices has led to heightened valuations, sparking concerns about potential market corrections. As 2025 unfolds, investors are urged to navigate the market with prudence, balancing the optimism of past performances with the reality of inflated valuations, and preparing for possible shifts in the economic landscape.

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