Great Expectations
First Quarter 2025
“All good stocks rise and keep rising, but not everything that is rising is a good stock.” – Thomas Phelps, Author
As 2024 concluded, U.S. equity markets finished off one of the better return periods in recent history. The S&P 500 Index rose by double-digit percentage amounts in five of the last six calendar years, with the exception being the brief bear market in 2022—the hangover from the post-COVID stimulus euphoria.
While investors can rejoice when viewing their higher brokerage account balances, it is prudent to reflect on how this growth occurred and whether (or not) we can expect a repeat performance in the latter part of this decade.
Underlying Forces
When markets rise by higher-than-average amounts, it is usually possible to identify underlying causes. Historically, significant tax law changes, shifts in economic cycles, groundbreaking technologies, or market underpricing have helped lead to years of exceptional returns. Over the past six years, three unique circumstances stand out as likely contributors to the impressive performance we have seen.
Cause #1: Room for Price Appreciation
As 2019 began, U.S. stocks had plateaued. The effects of the 2018 tax cuts had dissipated and economic growth was hovering around 1-2%. Economists were not expecting significant earnings growth, even from some of the largest tech companies. For example, Apple, Inc., the second-largest company in the S&P 500 at the time (with a 3.4% weighting in the index) was trading at price-to-earnings ratio of just 12x. (The longer-term average for stocks in the S&P 500 is anywhere from 16x-18x earnings.)
This indicated the market expected little if any earnings growth from Apple (and many other companies) for the foreseeable future. The “bar” for company performance was fairly low, meaning many stocks had room to climb just to return to more historically typical valuations.
Contrast that with current market conditions, where the S&P 500 sits at almost 27x earnings, and tech companies like Apple are closer to 40x earnings. This signals the “bar” for earnings growth has now been set much higher.
Cause #2: Money From Nowhere
The monetary stimulus funneled into the economy from the Federal Reserve and direct fiscal support from the U.S. Government played a second, pivotal role in jump-starting expectations and company earnings from the bottom of the COVID-induced decline through the 2021 bull market.
Through “Quantitative Easing,” the funds from the Federal Reserve were created quite literally from nothing, with the expectation that “Quantitative Tightening” in subsequent years would gradually withdraw this liquidity from the economy. The U.S. Government, meanwhile, embarked on a borrowing spree, distributing trillions of dollars directly to taxpayers over a short period, effectively borrowing against future generations.
This explosion in dollars in circulation not only contributed to the inflationary cycle the country soon found itself in, but also to the growth in earnings of companies in the S&P 500, welcome recipients of the resulting consumer spending in 2020 and 2021.
Cause #3: The Rise of AI
A third driver of the exceptional market performance, particularly in the technology sector, was the sudden and substantial investment in and growth of the AI (artificial intelligence) market. Near the end of 2022, OpenAI (backed by Microsoft) released ChatGPT to the public, and almost overnight the conversation around how AI might transform the workplace, and overall productivity, took center stage.
The largest U.S. tech companies began pouring tens of billions of dollars into developing proprietary AI models aimed at enhancing both consumer-facing applications and internal productivity processes. Beneficiaries of this spending included chip designers and producers, data-center builders, and even ancillary providers like utilities as well. This spending by the tech giants increased the earnings of those receiving it and helped push broader corporate earnings higher through 2023-2024.
The expectations for AI-driven productivity enhancements throughout the economy are substantial. At some point, large tech companies leading the AI charge are going to need to see a significant return on their investments, or the capital spending spigot may be turned off, creating a drag on the broader market. Indeed, there is a chance that capital expenditures from large companies on AI-related pursuits may prove to be the “canary in the coal mine” signaling the eventual end of this bull market cycle if they begin to decline. For now, however, the canary seems to be doing just fine.
Expectations Reexamined
The three primary factors we have discussed, among others, helped explain the rise of the market over the past five to six years. At this point, the historical underpricing we saw at the beginning of the period has been reversed, and the flow of “money from nowhere” has ended. Based on the current pricing of most large cap U.S. companies, expectations for stock market returns through the rest of this decade are quite high. Hopes for the transformative impact of AI are presumably a key reason.
At Mitchell Sinkler & Starr, we are optimistic that earnings growth, assisted by large productivity boosts, can, in fact, meet these expectations. However, the circumstances call for constant vigilance. In the event anticipated productivity boosts do not occur, we would expect more volatile stock market conditions in the second half of this decade.
– Mitchell Sinkler & Starr’s Portfolio Managers
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