Taking Stock: Q1 2025 equity market outlook

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Key takeaways

Can equities three-peat in 2025? With U.S. stocks on pace for a second year of strongly positive returns ― and one of their best years in the past three decades ― we look forward to the start of 2025 and the factors that could make or break the recent trend. As Q1 nears, we see:

• Market and economic tailwinds to start the year
• Old uncertainties replaced with some new ones
• A compelling case for large-cap value stocks

The S&P 500 Index posted its best month of the year in November, with a clear election result and a “no-surprise” Fed rate cut providing support. Annual performance to date rivals the index’s 2023 return of 26%, a notable achievement given that U.S. stocks have posted total returns above 20% in two consecutive years only nine times since 1928 (in less than 10% of rolling two-year periods).* 

The composition of 2024 performance looks very different from 2023, when the “tech-plus” sectors led the charge. A mid-year sector rotation and overall market broadening in 2024 (see chart below) cut the return contribution of the top-seven S&P 500 stocks (the “Magnificent 7”) from 60% in the first half to 23% in the second half through November. We see continued broadening presenting attractive stock selection opportunities as the market rewards a larger swath of fundamentally sound stocks.

Broadening toward more balance
Sector performance versus broad market, 2024

This bull still has legs

Investors have been generously rewarded by U.S. stocks over the past two years. What next? We enter 2025 optimistic yet balanced in our outlook, cognizant that two years of big gains and a broadening market suggests a lot of good news is priced into a growing number of stocks. At the same time, we are still seeing enough appreciation potential across individual companies to maintain a constructive, risk-on stance.

The broad market may not deliver another year of outsized double-digit gains. Our analysis finds the historical incidence of 20%+ returns three years in a row drops to 3% of all observations since 1928. In many years of consecutive outsized returns, particularly in the 1990s, both margins and valuations were starting from much lower levels. Yet we do see potential for returns to normalize toward the annual average (that being just below 11% since S&P 500 inception in 1957). We also see potential for skilled stock picking to enhance that outcome, as the broadening trend continues and as winners and losers emerge across various sectors. We reiterate our view that what you don’t own will be as important as what you do.

Positive drivers

As the new year begins, we see several factors supporting stocks.

Uncertainty eased. The quick and decisive election result removed a key uncertainty that had been hanging over the market. The rally that followed could have legs into the start of 2025, as the prospect of tax cuts and deregulation across key industries lends support. While the impact of some policies like tariffs and immigration is more uncertain, history augers well, with a long-term record of positive returns in the first year of a Presidential term.

Favorable economic backdrop. The U.S. economy appears strong on many measures. Unemployment has inched up but remains low at 4.2% as of November; consumers are showing resilience, notwithstanding some stress among the lower-income cohort; and a tight housing market is contributing to historically high home equity values and a related wealth effect.

Corporate change. We’re in a period of accelerating corporate change ― from new products (both AI itself and AI-inspired) to changes in company leadership and corporate strategy. Management turnover, as disclosed in company press releases, has shown a clear uptick (see chart below) and CEO departures through October of this year represent the highest year-to-date total as recorded by Challenger, Gray & Christmas since 2002. We expect M&A activity also could pick up in an environment of less restrictive regulation.

Shake-ups at the top
Rise in mentions of ‘management change,’ 2013-2024

Long-term structural trends (aka mega forces) are also contributing to this atmosphere of change. These include the transformative effects of AI, aging populations, energy transition, geopolitical fragmentation and shifting supply chains. Broad indexes will ride the waves of change, but we believe active investors are better equipped with the dynamism to take advantage of the opportunities and risks that this pace of change can present. Even the most potent mega forces historically have not moved in a straight line, making the ability to adapt and adjust a critical asset.

Widening market breadth. Earnings and valuations together suggest the strong potential for a continued broadening of the market. Our analysis of S&P 500 data finds that earnings for the Mag 7 stocks outgrew the broader market by 37% in 2023. This earnings gap narrowed throughout 2024 and we see it declining to 7.5% in 2025. Yet the valuation differential between these market leaders and the rest remains wide. We believe this translates into exciting stock-picking opportunities, particularly amid an organically changing roster of winners and losers.

Risk aware

The outlook is not without risks. Clarity in some areas is offset by uncertainty in others. New policies around trade and immigration could be inflationary across time. More broadly, there are undertones of consternation over the prospect for future inflation. These concerns are not without merit. In prior cycles when inflation was 6% or higher, a second wave of 6% inflation followed in nine out of 10 instances, according to a 2024 Strategas study of 23 developed market countries across more than 2,000 years of data. We saw this in the 1970s in the U.S.

Other policy changes under a new administration are yet to be determined, and geopolitical risks remain elevated. We have a constant eye on the equity risk premium (ERP), which measures the value of stocks relative to bonds. While the ERP is low for some of the priciest areas of the market, including the mega-caps, we find that it remains well in line with historical averages for the equal-weighted S&P 500 Index.

Revisiting value stocks

One notable development amid the expanding market breadth we’ve observed since mid-2024 has been the neck-and-neck performance of value and growth stocks. This comes after two exceptional years for growth that punctuated more than a decade of leadership versus value.

While we don’t believe growth momentum is exhausted, we do see several reasons why investors should consider revisiting ― and potentially increasing ― their exposure to large-cap value stocks. We discuss why many investors may be unintentionally underweight value and why active strategies may be appropriate for closing the gap in the Q1 edition of Taking Stock.

Bottom line

Across styles, sectors and geographies, we believe nimbleness and selectivity will be important to navigating markets in the coming months. If change will be a hallmark of 2025, we expect this will be a pivotal period for active managers with the flexibility and expertise to navigate the vagaries and opportunities ahead.

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