Since 1928, there has only been 3 times that stocks have gained 25% or more in back to back years. Here is what happened the following year:
- 1935: +46.7% 1936: +31.9% ——- 1937: -35.3%
- 1954: +52.6% 1955: +32.6% ——— 1956: +7.4%
- 1997: +33.1% 1998: +28.3% ———- 1999: +20.9%
So the last two instances saw stocks continue their gains the following year. But the one negative instance was quite bad! However the point is that stocks don’t have to go down just because they’ve had a solid run.
To break down our 2025 preview we’ll review how stock market returns originate. The equation to calculate stock market returns is simple:
Earnings growth + dividend yield + change in valuation
The 1st two components can be quantified, but the last (change in valuation) is almost impossible to predict with any consistency. You basically have to predict how a multitude of investors are going to react on a short time frame. Good luck with that! Valuation is also influenced by interest rates, with higher rates usually resulting in lower valuations over time and vice versa.
We’ll start with dividend yield, since that’s perhaps the easiest to quantify. The current dividend yield on the S&P 500 is 1.23%.
Next we turn to earnings growth. 2024 isn’t officially in the books since companies still haven’t reported Q4 2024 results yet. But current estimates for 2025 are +12.9% based against 2024 results so far and recent history has seen earnings results come in about +8.5% above consensus estimates. So its possible that 12.9% in EPS growth for 2025 is on the conservative side.
These are only estimates, but they remain a solid base line as long as the economy can avoid recession. During a recession, all bets are off. Based on current economic data, I place about a 30% chance of recession over the next 12 months.
So we have 1.23% dividend yield plus a baseline estimate of 12.9% earnings growth, which equals +14.13%. But here’s the tricky part; trying to predict what the price to earnings multiple (valuations) will do in 2025. The PE ratio increased about +16% in 2024, and +23% in 2023, contributing to the majority of the stock markets total returns.
However going into 2025, I don’t think we can count on that to continue. The S&P 500 is currently trading at 22.7 times the earnings estimates for the next 12 months. We have to go back to the depths of the COVID situation, when the economy was forced to shut down, to find a time when valuations were this stretched.
Put another way, the above chart shows how far above or below the markets PE ratio has been in relation to its historical average. Right now valuation is about 35% above its 15 year average. Once again, the last time its been this stretched is during the depths of COVID.
However the big difference here is interest rates. The last time the PE was this high, back in 2020, rates were only 1%. So even though the PE looked expensive, stocks remained attractively valued relative to fixed income alternatives.
Fast forward to today and the above chart shows the dilemma on valuations. The earnings yield on stocks compared to bonds shows that stocks are overvalued, based on current interest rates, for the first time since the great financial crisis of 2008. It’s called a negative equity risk premium.
So that’s the conundrum. We could very well get 15% to 20% between EPS growth and dividends, but only to see valuations contract by an equal amount, resulting in little to no gains in the stock market (or even negative returns if valuations contract even more!). Unfortunately its impossible to predict so I’m not even going to try. But what I’ll say is that interest rates will play an important role in 2025. If the 10 year rate breaks above 5% somehow, I think its pretty safe to say that it will sooner or later have a negative effect on stocks.
But I’m not going to leave you there. We’ll be heading into year 1 of a new administration in 2025. There is no doubt a lot of uncertainty over what economic policies will look like. I’m not even going to get into potential outcomes yet since we don’t even know any of the details yet. Let’s just break down the data.
In the above chart, I compiled the historical data since 1928, breaking down the 4 year presidential cycle and how stocks have behaved throughout. We can see that year 2 is clearly the weakest, and year 3 is strongest. But year 1 has also seen below average returns.
In fact, year 1 & 2 have clearly been the weakest when we see that the market has finished positive only 58% of the time. Basically almost a coin flip. While year 3 & 4 have been the strongest. In fact, the last time a year 3 finished negative for stocks, was 1939!
But this may be misleading. Recent history has shown year 1’s have been very strong. The stock returns over the last four “year 1’s” are as follows, +28.5%, +21.6%, +32.2%, +25.9%.
In fact, out of the last 10 “year 1’s”, there was only one instance where stocks closed the year negative and the average gain was a solid +20.7%.
Let’s drill down even deeper with more recent data. The above chart shows the average quarterly returns throughout the 4 year presidential cycle over the last 30 years. We can see Q1 of year 1 has been one of the weakest quarters on record, but things have tended to get better as the year progresses.
Recent history shows that Q1 of year 1 has finished positive only 57% of the time, confirming its recent trend as being one of the weakest. But after that things have gotten better as the year progresses, with Q2 and Q4 of year 1 finishing positive 100% of the time since 1994.
2025 Prediction
I predict we’ll have a 10% – 15% market correction this year (perfectly normal within a bull market trend), probably starting sometime in Q1 based on seasonality. But ultimately, stocks will finish the year with a gain in the range of +5% to +10%. Based primarily on solid earnings growth, rather than PE expansion, as has been the case for the last 2 years.
But this is nothing more than an educated guess based on seasonality and market analysis. Please don’t make any decisions based on this prediction! You will no doubt hear a lot of noise regarding economic and fed policy. Will tariffs be inflationary? Will retaliatory tariffs cripple economic growth? Will the Fed make a policy mistake resulting in another inflation flare up? Will corporate tax cuts be enough to offset a slowdown? Will some black swan event occur that no one sees coming? The list goes on. I’ll remind you of what the late great Charlie Munger (Warren Buffett’s right hand man) famously said, “keep your head as others lose theirs.”
All we can do is take what the market gives us. What I will actually be doing is allocating the majority of new money towards fixed income with maturity dates from 5 years and less. If we do get that correction, then I’ll raise money by selling bonds and buying stocks at a discount. The most important thing is to focus on what we can control, which is risk management and making sure we have enough cash to cover all short term expenses. So as to avoid having to be a seller in the middle of a market selloff.
Wishing you all a happy, healthy, and prosperous new year.