Put a Bow on It

Quite a year, especially for those invested in U.S. equities. Let’s keep it short this month, wrap it up and get you back to preparing for the holidays.

The postelection rally has taken the S&P 500 close to a 30% return for the year as of filming. Other major indices worldwide are likely to finish the year comfortably in positive territory. Multiple expansion has been the primary driver of returns across markets, both domestically and globally. Despite stretched valuations, U.S. exceptionalism in a pro-business administration provides some tailwinds.

Cumulative flows into U.S. equities have dwarf flows into international and emerging markets this year and are likely to continue. Now I hear some of you saying, “Chuck, these levels and valuations aren’t sustainable, are they?” Well, let’s take a deeper look.

Chart(s) 1, 1:09— Focus your attention first to the bottom chart (S&P 500 Forward Price/Earnings Ratio). The forward price-to-earnings ratio for the S&P 500 is rich by historical standards. As I mentioned, multiple expansion has driven much of this year’s return. Shifting to the upper-right chart (U.S. Equity Market: Valuations), we dig a little deeper into the valuation picture. Like last year, the “Magnificent 7” have driven a good portion of the S&P 500’s return and contributed disproportionately to the valuation level.

Valuation levels, ex-the Magnificent 7, look more reasonable and closer to the 15-year average for the index. But it hasn’t just been multiple expansion. Earnings growth has been solid as well, and we think that continues and estimate that earnings [will] grow even more in 2025 as depicted in the upper-left chart (S&P 500 Earnings Growth: Forecast (%)).

One can reason that the bull market can continue without further multiple expansion if the earnings estimates prove true, albeit with more modest returns than we’ve enjoyed the past two years. If the incoming administration is successful [in] implementing tax cuts, that may be the biggest influence on the overall level of earnings and could accelerate profits.

While the Magnificent 7 have driven the returns and valuation, a much welcome broadening has occurred in 2024.

Chart 2, 2:33— A comparison of 2023 and 2024 returns across the 11 sectors in the S&P 500 reveals a more even distribution of returns, with all 11 in positive territory and 6 of those 11 above 20%.

Attractive relative valuations, a slow-fed easing cycle and potential pro-business policies bode well for more cyclical sectors and continued broadening. Broadening may well extend to capitalization as well. Small-cap stocks are trading at relative discounts to large-cap stocks, and in addition, they are more cyclical.

To close and put a bow on this year, while overall market valuations remain elevated, specific sectors present more attractive opportunities due to better relative valuations.

The S&P 500’s 2025 performance will hinge on tax policy’s impact on earnings. Small-cap stocks are gaining appeal, benefiting from their domestic focus, favorable valuations and sector diversification. Sustained market progress will require broader participation in earnings and returns across sectors. And finally, the Fed’s [Federal Reserve’s] easing cycle is expected to provide a strong tailwind for equities, particularly in early 2025.