Is the Glass Still Half Full?
The S&P 500 rose 23% in 2024, following a 24% gain in 2023. As we enter 2025, we continue to expect solid economic growth, stronger US productivity, and favorable interest rate policies by global central banks. The US is expected to remain the global economic growth driver with expansion of the current business cycle, increased AI-related capital spending, solid employment growth, and prospects for increasing capital markets activities. Despite this favorable backdrop, there are a variety of factors that may affect US equity performance in 2025.
First, we believe much of the robust earnings growth in 2023 and 2024 has been reflected in equity valuations, especially in the fastest-growing AI-related stocks (see below). Over the last two years, higher interest rates combined with the AI capex boom were a key driver of outsized performance by a narrow group of stocks. However, we think these elevated valuation levels leave little margin for error. We think it also places a constraint on the upside for outsized equity gains in 2025.
Recall, in our 3Q 2024 Quarterly Newsletter, we stated:
Currently, the weight of the largest 10 stocks in the S&P 500 is about 37%, which is in the 97th percentile since 1964 and well above the Tech Bubble. We believe this elevated level of extended concentration may begin to unwind in 2025 as investors recognize more attractive combinations of valuations+ earnings growth in the other non-Mag 7 stocks.
As we head into the earnings reporting season, Mag 7 earnings in aggregate are expected to increase +21.7% y/y in Q4 2024, with Nvidia, Amazon, Google, and Meta as standouts, while Microsoft and Apple forecast to grow less than 10%. This compares to the +9.7% growth expected for the remaining 493 S&P 500 companies, which would mark the best growth since Q2 2022.
Importantly, as we enter 2025, Mag 7 stocks are expected to grow earnings by about 18% (further deceleration), while the remaining 493 S&P 500 companies are expected to grow earnings by about 11% (further acceleration), according to Goldman Sachs. Furthermore, the earnings growth “gap” is expected to narrow further in 2026.
Elevated valuation multiples, higher investor expectations, and decelerating forward earnings growth rates are typically not a healthy combination for outsized equity performance. These are the characteristics that we currently see in Mag 7 stocks.
We believe the narrative has clearly shifted from the “recession/soft landing” debate in 2024 to continued economic expansion in the US economy. In our 3Q 2024 Quarterly Newsletter, we stated, “we are on the cusp of a new economic cycle.” As we wrap up the 4Q 2024 earnings reports from the large financial institutions, we are increasingly positive on the US economy for 2025. Credit, deposit, and loan growth trends remain positive. Troubled areas of the economy like commercial real estate appear to be slowly healing.
At Oliver Luxxe Assets, we seek to identify businesses with attractive return on invested capital and durable cash flow generation trading at undemanding valuations. Our ongoing analysis continues to support our strategy, and our conviction is reinforced as we see many opportunities in the cyclical areas of the US economy where profit margins are expanding from depressed levels and have low investor expectations. We believe this combination could drive attractive returns over the coming years.