Catching a Rising Star

by: Kenneth J. Entenmann CFA®, December 31, 2024

2024 was a year of resilience. At the beginning of the year, expectations for 2024 were quite muted. The S&P 500 index began the year at 4769 and earnings were $217. The consensus Wall Street forecast called for meager returns in the low-to-mid single digits. The concern was the Fed’s aggressive rate increases in 2022-2023 would finally result in a “Waiting for Godot” recession. Inflation would come crashing down to the Fed’s 2% target. That would allow the Fed to ride to the rescue with a change in monetary policy beginning in March and followed by as many as 6 rate cuts in 2024. Well, we are still waiting for the recession!

Economic growth accelerated throughout the year and will settle at an annual growth rate of 2.5%, far from the pessimistic 1-1.5% consensus or even recession. The 2nd half 2024 GDP will exceed 3%! Better than expected growth led to better corporate profit margins and earnings. S&P 500 will end 2024 with earnings of $238, a very healthy 9.6% year-over-year improvement. Technology stocks led the way, driven by expectations for Artificial Intelligence (AI). The S&P 500 is ending the year near 5800, up more than 20% for the second consecutive year. However, this strong economic growth also resulted in inflation remaining “stickier” than expected. While the rate of growth in inflation did recede in 2024, it flatlined in the 2nd half of the year. Core Consumer Price Index (CPI) stuck above 3%, well above the Fed’s target of 2%. The Fed finally did change monetary policy direction in September, not March, and cut rates only 3 times in 2024. In short, the 20% S&P 500 return was driven by earnings growth and investors willingness to pay a higher price/earnings ratio (P/E) for stocks. The P/E will end the year at a historically high 21 times earnings, or as this blog often says, “priced for perfection.” Maintaining a high P/E will require a cooperative Fed and earnings to come through as expected.

The Fed is looking to catch a rising star. “N Star”, or N*, is the theoretical interest rate that is neither restrictive nor stimulative to economic growth. Of course, no one knows the value of N*. At its December meeting, the Fed cut rates by .25%, the last of three cuts since September. The action brought the Fed Funds Rate down 100 basis points from its peak, to 4.25-4.5% range. Several Fed talking heads have justified the action based on their belief that rates are still restrictive, or above N*. Interesting! Maybe the Fed has a unique definition of restrictive. The economy is accelerating and growing well above long-term trend, inflation remains sticky, unemployment hovers at 4.2%, fiscal spending remains reckless, credit spreads are historically low, speculative assets such as gold and cryptocurrencies have spiked, the S&P 500 trades near record highs. And the yield on the 10-year Treasury note is 4.55%, up nearly 100 basis points since the Fed began cutting rates in September. If that is restrictive, I would hate to see stimulating! While they would never say it, perhaps the Fed knows this looks suspicious. At the meeting, they also “managed expectations” for additional rate cuts in 2025 down to two. The markets were forecasting as many as 4-6 rate cuts. It seems that N* is rising! Prior to the meeting, expectations for N* were in the low 3s, maybe even 2.9%. Now the estimate of N* is more like 3.5%. GASP! How is a stock market trading at 21x earnings going to go up without the Fed’s support? Ever since the December Fed meeting, the S&P 500 has lost nearly 2.5%. The market seems to be concluding that a rising N* will mean higher than expected rates in 2025. The idea that easy monetary policy would provide material support to record high valuations is fading rapidly.

If the equity markets are to sustain their remarkable growth, it will have to do it the old fashion way through earnings growth. The good news is the estimate for S&P 500 earnings for 2025 is $272. As noted above, 2024 earnings should be around $237. That is 15% growth! That’s great, but also well known. The P/E at 21x earnings have already priced the strong earnings projections. Without support from interest rates, those earnings better come through. Once again, the primary drivers of earnings optimism is continued strong economic growth and AI. At the moment, it does appear that the economy remains on solid footing. Growth may slow from its torrid above trend pace, but there is little talk of the dreaded recession. Economic growth should support earnings.

The big earnings uncertainty revolves around AI. There is no shortage of claims of the paradigm shifting impact of AI. AI will increase productivity across all industries and result in even better earnings. Recent productivity metrics have indeed been improving. The large, dominant Tech companies are spending billions on the AI race. The costs are certain. Yet very few companies can get specific as to when the return on investment will occur. “AI is going to be HUGE!” Maybe. But when, and by how much? Didn’t you hear, AI is going to be huge! Certain costs, uncertain profits. That is always true, but there is a fine line between “irrational exuberance” and reality. It’s going to be huge is proving difficult to quantify. At 21x earnings, the earnings estimates better be right.

I am not a fan of annual forecasts. They tend to be awful, and that includes any projections in this blog. That is why we never provide actual forecasts, but instead try to provide a simple assessment of where the economy and markets are at any given time. We remain unapologetic fans of long-term investing based on the risk profile of the investor. Market timing based on some brilliant market prognosticator has and always will be folly. Recalling 2024, the consensus Wall Street price target for the S&P 500 was 4800 to 4900, a forecast of a paltry 2% projected return. It will end the year at 5800, up nearly 23%. Investors who ignored the weak forecasts and stayed in the market were handsomely rewarded.

As we enter a new year, the economy is on solid footing and earnings estimates are robust. But rising N* is likely to be less supportive and the market has already priced in much of this optimism. As always, the world remains a contentious place. The governments of the West are, to put it politely, in disarray. Economic growth outside the US remains anemic. Military conflicts continue around the globe. There is always the certainty that something uncertain will come along.

2025 will be no different. Investors should reassess their risk profile. The strong equity performance and the late-year rise of interest rates have shifted the asset allocation of most portfolios. The weight of riskier assets is greater in most portfolios. Rebalancing the asset allocation is a time-tested way to control risk and manage returns. And by all means, stay invested, no matter what the talking heads say! Let’s hope for a third consecutive year of 20%+ S&P 500 returns. But beware of a rising N* and manage your New Year expectations!