This article first appeared in The Edge Malaysia Weekly on January 13, 2025 - January 19, 2025

THIS time last year, I wrote about how I saw the US stock market performing in 2024, after its spectacular 26.3% total return in 2023. Given the strong earnings growth in the US, robust capital expenditure around artificial intelligence (AI) and anticipated interest rate cuts, my view was that the US market could deliver a return of over 7% for 2024 or a total return of about 9%. It turns out I was far too conservative.

Here is how 2024 panned out for investors: The US barometer S&P 500 index was up a whopping 24.6% for the year, inclusive of dividends. At one point just before Christmas,  the index was up 28% including reinvested dividends. 2023 and 2024 were the market’s two best years  since the 1990s. For those old enough to recall,  back then, the market kept going for three more years after those two great years.

If you had invested US$1,000 in an S&P 500 exchange traded fund (ETF) in January 2023, you are up 57.3% in US dollar terms including reinvested dividends over two years. Over a five-year period, you have nearly doubled your money in US dollars. That period includes the worst pandemic in over a hundred years and a horrendous market in 2022 when the US Federal Reserve was racing to raise interest rates to rein in runaway inflation. Over 15 years, investors have gotten a 13.9% annualised return including reinvested dividends from investing in the S&P500, compared with the 6% annualised total return they would have earned in Europe, 2.6% in China and 6.9% in India.

A year ago, the US market gauge was trading at around 19 times 12-month forward earnings, or just above its five-year average of 18.8 times earnings. Today, the S&P 500 trades at just 21.4 times forecast earnings for 2025. So, investors saw a decent multiple expansion as the market ran way ahead of earnings growth this past year. Is it time to sell? Unfortunately, a high price-to-earnings (PE) multiple is not a stock market sell signal. Indeed, valuation is often a bad market-timing tool. In September 2020, when the S&P 500 was hovering around 3,500, the index’s forward PE multiple was 24.1 times.

While the market may seem overpriced compared with historical valuations, it may not be fair to compare the valuations of today’s large, global, fast-growing, asset-light tech companies that are insensitive to interest rates, have gross margins of 50% to 80% and are sitting on tens of billions of net cash on their balance sheets, with asset-heavy, debt-laden industrial companies that dominated corporate America 20 or 30 years ago.

Corporate earnings have grown faster than the market over the past five years. That’s because the market anticipates faster future earnings growth. Eventually, earnings catch up with the market. “The stretched valuation environment is a product of enthusiasm around equities,” Liz Ann Sonders, chief equity strategist of Charles Schwab, the biggest US stockbroking firm, wrote in a recent note. “Multiples can continue to move higher, as was the case in the late-1990s, and there isn’t a strong historical relationship between valuation and forward performance.”

Jonathan Golub, chief US strategist for UBS in New York, believes “valuations have an upward bias in non-recessionary periods, but correct sharply around economic contractions”. Morgan Stanley’s US strategist Michael Wilson argued recently that “it’s rare to see significant multiple compression in periods of above average earnings growth and accommodative monetary policy.”

So, how should investors look at 2025? America is still among the fastest growing developed economies in the world. The consensus estimate for US gross domestic product growth is around 2.7% in 2024 and the economy is likely to grow 2.5% in 2025. Sales for US companies are forecast to grow 5% next year. Yet markets are driven primarily by earnings growth. Earnings for the 500 top US firms grew 9.7% in 2024 to US$245. Consensus estimates of Wall Street strategists are for earnings per share growth of 16% in 2025. That would take total S&P 500 earnings to US$285 in the new year. For 2026, forecasts are for 12% earnings growth, which will put S&P 500 earnings at just under US$320. Assuming no further multiple expansion, the index should trade around 7,040 by the end of 2025.

What’s driving US earnings? Interest rate cuts, for one. The Fed has slashed rates three times this year, bringing them down from 5.25% to 4.25%. While rates are likely to stay higher for longer because inflation is likely to remain well above 2%, markets are still pricing in a further 75 basis points of cuts in 2025. That will take the fed funds rate down to 3.5% next year. Lower rates will be a huge relief to smaller listed companies that have struggling in recent years.

Another big plus: the return of billionaire former property developer Trump to the White House. The market sees Trump as probably one of the most pro-business presidents in decades. He has picked former hedge fund manager Scott Bessent as his treasury secretary and billionaire Howard Lutnick, CEO of Wall Street investment bank Cantor Fitzgerald, as the next commerce secretary. Indeed, Trump sees the S&P 500 as a key measure of his administration’s success. The president-elect has promised sweeping deregulation as well as more corporate and personal income tax cuts, vowing to slash corporate taxes from 21% currently to 15%. Corporate tax cuts will likely boost dividend payouts and share buybacks. In 2024, stock buybacks by US listed companies again exceeded US$1 trillion (RM4.5 trillion), having dipped to just under that figure in 2023. The Trump agenda is expected to unleash animal spirits that could add fuel to the ongoing market rally.

Another key driver for the stock market is the upcoming wave of initial public offerings, or IPOs. Fintech giants like Stripe Inc and Klarna are readying their listings in the new year. Other IPO candidates include cloud computing start-up CoreWeave Inc, which rents out access to Nvidia AI chips and last raised funds at a US$23 billion valuation; data, analytics and AI firm Databricks, which last month raised funds at US$62 billion, and Elon Musk’s SpaceX, which owns the StarLink satellites and was recently valued at US$250 billion. Investment bankers are hoping that the new Trump administration’s policies will unleash a wave of mergers and acquisitions activity. Under outgoing president Joe Biden, the US Federal Trade Commission had blocked corporate mergers, deterring other companies from trying.

For his part, Trump has promised a much lighter regulatory touch and favours more corporate consolidation. Private equity giants are also expected to bring a number of their investee companies to the market and recycle the money they raise from those exits to make new acquisitions. Add in the benefits of reshoring, or bringing offshore manufacturing back from Asia, Canada and Mexico, which has helped trigger a manufacturing renaissance in America. Several large state-of-the-art semi­conductor chip plants are being built by Intel Corp, Taiwan’s TSMC and South Korea’s Samsung Electronics in Arizona, Texas and Ohio at a total cost of over US$100 billion. Because of tariffs and the realignment of global supply chains, some intermediate goods’ production has already begun shifting back to the US.

Trump has also roped in Musk, the world’s richest person (net worth over US$460 billion) and CEO of electric vehicle pioneer Tesla Inc, and another billionaire Vivek Ramaswamy to head the new Department of Government Efficiency or DOGE. The duo has promised to cut US$2 trillion in government waste, reduce needless spending, optimise pricing and produce greater efficiency. In 2024, the US government had revenues of US$4.92 trillion but spent US$6.75 trillion mostly on debt servicing, defence and social services, or annual deficit spending of US$1.82 trillion.

The US government balanced its budget in the 1990s under President Bill Clinton and started generating surpluses.  The US last had a surplus in 2001, the year Clinton left the White House.After the 9/11 terrorist attacks and the wars in Afghanistan and Iraq, defence spending surged and deficits grew. US federal debt has since soared to US$35.4 trillion. Trump wants to cut debts by growing the economy, and keep inflation low, which will in turn keep interest rates low and as such lower interest cost, the biggest item in federal spending.

There is also the ongoing AI boom, which has inflated valuations around some tech stocks, particularly chip players such as Nvidia Corp and Broadcom Inc. “US equities will do better in 2025 than other asset classes as the AI bubble inflates further,” notes John Higgins of Capital Economics in London. “We expect equities elsewhere to lag those in the US.” He expects US stocks to stay ahead of the pack as Trump’s tariffs weigh on other assets, including international stocks.

Another reason why investors are so bullish on US stocks: Top five US firms had a return on equity, or ROE, of 62% this past year. US firms reinvest a lot of their earnings, buy back bucketloads of their own shares and pay out tons in dividends. In comparison, the top five companies in the MSCI All Country World Index ex-US had an ROE of 39% while the top five listed emerging market firms had an ROE of just 13%. In 2022, US stocks made up under 60% of the total global market capitalisation; now they account for over 67%. The ROE gap between US companies and those from rest of the world is growing.

US households have not been so bullish on equities in over 40 years. The Conference Board, a non-profit US business think tank, regularly asks Americans how they feel about the stock market to gauge whether they are likely to buy more stocks, looking to trim their positions or expect to stay neutral on the market. In its latest survey, it found that over 51.4% of Americans expected markets to move higher over the next 12 months.

The last time Americans were so optimistic about the stock market was when Trump was sworn in for his first term as US president. The S&P 500 index rose 22% in the 12 months following that year’s peak bullishness. If, however, you had sold in January 2017 because you saw the exuberance as a contrarian indicator, you would have missed out on the 22% gains in the market. Over the past four decades, Americans were the most pessimistic about the US market in June 2008 — three months before the collapse of Lehman Brothers and the bursting of the subprime mortgage bubble, which triggered the start of the global financial crisis. If you viewed the extreme pessimism in early June 2008 as a contrarian indicator and actually bought stocks, you would have been down 21% over the next 12 months.

Don’t bet on this exuberance fading away at least in the first year of Trump’s second term. Most working Americans contribute to a 401(k) retirement savings account akin to provident funds in Asia. They set aside a portion of their own savings, which are matched by employers’ contributions, into these accounts. More than half of the new money pouring into these accounts goes directly into passive index funds like S&P 500 exchange traded funds. That in turn boosts valuations of the largest companies that dominate the market capitalisation-weighted indices.

Yet all parties eventually come to an end. It is likely that the US economy will show signs of slowing at some point soon or inflation rears its ugly head again, triggering another interest rate hiking cycle which in turn will jolt the market. “US incomes, stock prices and home prices are high, debt levels are low, interest rate sensitivity is low,and banks are more willing to lend to households,” notes Apollo Global’s economist Torsten Slok. “There are significant upside risks to US growth and  also to inflation and interest rates as we enter 2025,” he argues.

Assif Shameen is a technology and business writer based in North America

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