Market Commentary
2025 Outlook: Average is Lazy
As we close out 2024 and look forward to 2025, the usual suspects are putting out their 2025 market forecasts. Most of these forecasts are worthless before the compliance people even approve them, much less when they hit their destination email in-boxes.
This is not due to their accuracy, or lack thereof. After all, the writers are human, all too human, as Nietzsche said, even if they are smart and AI assisted when making guesses about a distant future full of random variables.
What makes these forecasts deficient is their lack of imagination and their reliance on the historical averages: average growth rates, average returns, and average distributions – all with the caveat that history doesn’t really repeat but it sure does rhyme.
“This happened in the past, it may or may not happen again, but an outcome close enough to something resembling that past is highly likely”. While there is a logic to understanding that the sun will rise again, this kind of analysis is not helpful because we know the sun will rise again, and therefore have no new marginal information on which base decisions regarding the allocation of capital.
Throwing shit at the wall is a not a real strategy.
Take for instance the idea is that the third year returns of a bull market are historically meh and sub-par. Intuitively this has some appeal, as an acceleration in economic growth rates tends to be strongest as the economy bounces back after a downturn.
Physics envy is real in this business, and it will cause some investors to misprice risk if they conflate cars with economic outcomes, or narrowly focus on the math of declining marginal change (1=>2 is +100%; 2=>3 is +50%, 3=>4 is +33%....) as a proxy for market outcomes. More so if a random historical pattern of returns supports the argument.
The basic math behind most S&P500 targets starts with the historical price return of 10.4% per year since 1928, and a total return of 11.7% per year in the same period. Thus, Friday’s S&P500 close of 6032.38 becomes 6659.74 (or something close enough) by YE 2025.
Pass Go and collect the year-end bonus. While not terribly imaginative, the argument above is historically defensible and will not get anyone fired.
The problem is this is not how real life plays out. Real life returns look like ‘dis 👇
Source: macrotrends.net
As the outperformance of the MAG-7 versus the other 493 components of the S&P500 and the rest of the world (RoW) have illustrated, returns from normal growth are not normally distributed.
Relying on average historical patterns does not consider changes to the economy, financial markets, regulatory structure, or technology over the course of cycles. Historical patterns also don’t consider the accelerating rate of evolutionary change in the aforementioned domains.
Think of Moore’s Law here, and how it is an experience-curve law where efficiency gains follow from experience and effort.
Why should an expected marginally declining economic growth rate in 2025, relative to 2024 and 2023, express itself today in the same way that a third-year expansion expressed itself in prior cycles from thirty or forty years ago? Industries have died and been born. Technology has advanced to mind boggling speeds where AI is writing its own software.
While sell-side analysts’ earnings estimates are often the target of cocktail party jokes, one of the ironies of the past decade is the underpricing of aggregate earnings growth fueled by FAANG stocks prior to the pandemic.
This underpricing manifested itself again as the Mag7 names smashed earnings expectations in the post pandemic period, despite concerns over rising interest rates. As we approach YE 2024, the average 2024 S&P500 target is now over 23 percentage points in the rear-view mirror from current reality.
To be clear, things could have gone the other way - for multiple reasons – namely the recession that never came. But what these projections reveal is unimaginative herd thinking that resulted in an underpricing of market outcomes relative to economic growth expectations.
Remember, the market is not the economy despite having a symbiotic and reflexive relationship with the economy. One must recognize that while sales and revenue growth are highly correlated to nominal GDP growth rates, market returns are driven by return on capital.
After the GFC, S&P500 profit margins hovered around 10% for almost a decade. Since the pandemic, they have averaged 12%. This, despite higher interest rates. Higher margins mean higher returns on capital, which lead to higher valuations. Today’s elevated valuations are a function of investor comfort and ongoing confidence in the dominance, scale, market share, and profitability of U.S. firms.
Higher returns on capital means is that there is an embedded operating leverage to growth, where incremental topline growth results in greater marginal earnings.
The above is corroborated by the data we have on increased post-pandemic productivity in the U.S. Long run productivity growth has averaged 2.1% since 1948. That number fell to 1.3% in the decade after the global financial crisis. The 2010’s were a period of low productivity growth despite the introduction and adoption of new technologies in the United States.
The one thing that changed bigly in the post-pandemic period is the labor market.
Full employment
Tight labor markets
Going back to Moore’s Law, it is Pinebrook’s imaginative conjecture that today’s labor market at full employment will have more efficiency gains in the third year of a bull market than the post GFC labor market did in its third year of recovery, and more efficiency gains than were had in prior cycles…if the labor market remains at full employment.
The reason is that labor market slack results in lost skills to the economy. The slow labor market recovery after the GFC is not only linked to a host of social issues, but also to a fall in productivity. This makes intuitive sense. If one has a protracted, involuntary separation from the labor market, it takes years to make up for lost pay, skills, and professional prestige (i.e., mobility).
Having a holistic appreciation for these economic nuances and their links to market outcomes contrasts with the third-year return dogma which represents a technical analysis approach to economic forecasting and market prognostication.
This is not to say that 2025 cannot offer sub-par returns. A lot of things can go wrong and off the rails. But going wrong because of yea the third year is quite literally astrology, which is what is filling people’s in-boxes across the global financial community as this note is being written.
It is here that Jan Hatzius and David Kostin of Goldman Sachs enter the chat, by establishing a year-end target of 6500 for the S&P500. They lay out their thinking in the “Odd Lots” podcast with Bloomberg’s Joe Weisenthal and Tracy Alloway.
They explicitly call for 5% topline revenue growth, derived from an expected 5% nominal GDP growth rate. Then they call for an 11% earnings growth rate for 2025.
Both foundational building blocks for their projection are exactly what one would expect given the historical experience of GDP and earnings growth. There is no new marginal information here.
As can be seen in the first chart, the range of market return outcomes that make up the averages is wide. The standard deviation around the mean 11.7% total return is 19.6%. Any total return for the S&P500 that is between is between -7.9% and 31.2% is within an average central distribution and unremarkable. Forecasts that lie between this range are intellectually equivalent to an 11.7% mean return.
The next step to a more robust analysis beyond a reliance on averages is examining the tail distribution of returns and contextualize and correlate them to their economic causality. Returns that are at the tails of the above range are the remarkable ones. Therefore, what is of interest to us are return years less than -7.9% and greater than 31.2%.