Light seeking light doth light of light beguile.
A gallup poll just weeks leading up to the recent election indicated that Americans perceived the nation to be at its most divided on key values over the last 30 years. In a country with two sides drifting ever further apart, this was at least one consensus: we can agree we disagree.
Interestingly, though, coming out of the election, more Americans are optimistic about the future. While the biggest increases are occurring among Republicans (not surprising), those with higher incomes, and Gen X and Baby Boomers, there are rises in optimism evident across both political parties, all income levels, and all age groups.
That optimism is also evident in the stock market, which is coming off of its best two-year run since 1997-1998. With the S&P 500 up an astounding 53% over the last 24 months and Americans optimistic going into 2025, investors should be careful not to be pollyannaish.
After inverting in July 2022, the US treasury yield curve remained so for a record 793 days. A classic recession indicator, economists, investors, and business leaders warned of a severe economic decline that didn’t come. This past September, the yield curve finally uninverted. Now many of those same voices are echoing that the reversal may also be warning of a recession.
It is true that it is not uncommon for the uninversion of a yield curve to serve as an antecedent to a recession. This typically occurs when short-term yields fall as the central bank cuts interest rates in response to a slowing economy in an attempt to stimulate growth.
But this does not appear to be the case in the United States currently. The Federal Reserve did indeed reduce the policy rate from 5.25-5.50% to 4.25-4.50% from September to December last year, but the economy is not slowing in any meaningful way. Even when the Fed initially cut in September, the economy grew 3.1% (adjusted for inflation) that quarter. For the 4th quarter that just wrapped up, the Federal Reserve Bank of Atlanta estimates the economy expanded 2.7%.
In fact, during this particular rate cutting cycle, nonfarm payrolls have actually increased. Excluding the month of October that was skewed by the Boeing strikes and Hurricane Milton, job growth has been strong.
The pickup in hiring is forcing the Federal Reserve to rethink its course after cutting rates the last three meetings and yields are responding in kind. The 10 year treasury yield is back to its highest level since November 2023.
This move higher in longer term yields combined with the Fed’s rate cuts (bringing short-term yields down) has contributed to the yield curve’s normalization. Historically, that has been a good thing for stocks. Since 1980, the median return for the stock market is nearly 17% in the subsequent 12 months after the yield curve uninverts.
Another factor driving optimism higher is continued productivity growth in the United States, which has eclipsed 2% for five consecutive quarters.
This trend sets the US apart from other global economic rivals. A recent October article in The Economist notes that “American business investment is the most potent kind: spending on research and development, which sows the seeds for future growth.” After trailing the Euro area in labor productivity for much of the 1990s, the US surpassed its rivals across the Atlantic around the turn of the millennium and its lead has widened significantly since the pandemic.
For 2025, analysts estimate S&P earnings will grow 14.8% from last year. If achieved, this would mark the fastest rate of growth for S&P earnings in seven years (ignoring 2021 when 2020 earnings were artificially suppressed due to sheltering-in-place).
Those strong earnings expectations, though, are fully priced in already. Even against those elevated targets, the stock market is trading above a 21x forward price-earnings (P/E) multiple, hovering around its highest valuation since the Dot Com period, which implies the market may be expecting more.
In part, the high valuation reflects the high multiples contained within America’s largest tech giants— colloquially referred to as the “Magnificent Seven.” Those seven companies: Apple, Amazon, Microsoft, Alphabet, Meta, Nvidia, and Tesla make up 33% of the overall value of the S&P 500 Index. In fact, when evaluating the performance of the S&P 500 excluding those seven companies over the last two years, the S&P 500 ex-Mag 7 would have registered very mediocre gains.
According to Capital Group, when excluding the Magnificent Seven, the S&P 500 has a forward P/E multiple of just about 15.5x. The Magnificent Seven, by comparison, has a forward P/E multiple of about 35x.
The primary driver of the investment performance for those tech companies, of course, is excitement around the future opportunities afforded through AI. Companies all around the world took a significant evolutionary step in their adoption of AI in 2024. Mckinsey & Company reported from their global survey a big jump in AI adoption, particularly in the use of generative AI, after years of little change.
As adoption is increasing exponentially, so too is investment into AI capital expenditure (capex). The capex budgets of America’s largest tech companies jumped in 2024 and is expected to increase further this year.
With the S&P 500 having eclipsed 20% for consecutive years for just the first time since the Dot Com period, the comparisons between AI and the internet boom are inevitable, and many fear history may repeat itself and stocks will suffer a similar fate to when the internet bubble burst.
While the comparisons are understandable, there are key distinctions. The first is AI infrastructure is largely being financed by tech companies flush with cash instead of the debt and venture capital money primarily utilized in the 1990s. Furthermore, investments into AI today are less speculative than three decades ago and are more motivated by observable efficiency gains. The Harvard Business Review reported at the beginning of the year that “while AI initiatives are at an early stage for most Fortune 1000 companies, 93.7% report that they’ve seen some business value from their AI investment, meaning that they are seeing quantifiable business results, which can be measured by metrics including increased customer acquisition and retention, improved customer satisfaction, and revenue and productivity improvements.”
With a new administration preparing to enter the White House, gears are already in motion for changes to come. President-elect Trump’s nominated Treasury Secretary, Scott Bessent, could play a particularly key role as the government’s top economic official. He has outlined a 3-3-3 playbook that would aim to reduce the fiscal gap (federal deficit as a percentage of GDP) to 3%, maintain a GDP growth rate of 3%, and increase domestic oil production by 3 million barrels a day. Those targets, while ambitious, may also be mutually reinforcing. For example, increasing oil production to decrease inflation could boost real GDP and additional growth could also assist in bringing down the fiscal gap.
Much of this is predicated, though, on bringing inflation down. That does not appear to be happening yet; if anything, fears of reinflation are more prevalent for now. Whether it’s possible to utilize business investment and deregulation to fuel growth while lowering inflation remains to be seen. The prospect of national tariffs only makes this a more daunting endeavor. Those obstacles are not just economic in nature but may disturb the geopolitical balance, which are risks that can be more difficult to quantify and anticipate.
There is indeed much to be optimistic about – an AI revolution, pro-business legislation, and an efficient US economy point to a bright future. Investors need to be careful, though, not to let that optimism obscure their sight of the hurdles that will invariably come.
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