CONTRIBUTORS
Shep Perkins, CFA
Chief Investment Officer
Investors looking to gauge the direction of markets in 2025 may want to look back a few decades. The 1990s—a phenomenal 10-year period for US equity markets—offers great perspective and reasons for optimism.
For the decade of the 1990s, the S&P 500 Index delivered an impressive 430% total return. This included annual returns of more than 20% for five consecutive years, 1995–1999.1 The decade had a rough start with a recession, and 10-year Treasury yields spiked as “bond vigilantes” worked to coax the Clinton administration and Congress to rein in government spending. A number of other headwinds—from the 1997 Asian financial crisis to the 1998 Russian ruble crisis and even the threat in 1999 of disruptions from Y2K—brought fears of financial contagion and bouts of extreme volatility to equity markets. On average, the VIX (Cboe Volatility Index) was in the mid-20s in the 1990s, versus a more benign mid-teens average in the current decade.2 Despite this higher monthly volatility, the equity market consistently marched higher over time.
Emerging world-changing technology moved markets
So what propelled those 1990s markets? US gross domestic product grew at a robust 3%-5%, yet inflation was moderate. But most notable were three coinciding technology-led investment super cycles. One was “WinTel,” an alliance between Microsoft and chipmaker Intel that bolstered the widespread adoption of personal computers. At the same time, the dawn of the world wide web and the commercialization of mobile/wireless technology prompted a massive investment cycle in telecommunications infrastructure.
The parallel today is artificial intelligence (AI)—another nascent and potentially world-changing technology. For many businesses, AI is perceived as a “winner-take-all” opportunity or threat, with the “losers” left empty handed. This has spurred a super cycle of investment spending with implications that transcend the technology sector.
Like in the 1990s, we see coinciding mega trillion-dollar investment waves today, many in response to disruptive technology. Today’s investments are tied to power infrastructure upgrades, global supply chain redundancy, climate solutions and carbon reduction, and a US housing shortage. And similar to the 1990s, there are smoldering hotspots for geopolitical and economic crises. For the latter, this includes an ugly imbalance in commercial real estate, massive government deficits that need to be refinanced, and a precarious economic imbalance in China.
Comparable rate environments
In the 1990s, the federal funds rate and 10-year Treasury yields were typically 5% or higher. Inflation was 2.5%–3.0%, consistently above the Federal Reserve’s (Fed’s)current target of 2% and similar to this calendar year. Also, in the 1990s, real yields were quite positive, meaning interest rates were higher than inflation, as they finally are again today. In contrast, for most of the past 15 years—in the aftermath of the global financial crisis—we had negative real yields and “cheap money” in the form of lower borrowing costs.
Today, one pronounced fear is that, with positive real yields and “easy money” in the rear-view mirror, the economy is sure to sputter without more aggressive rate-cutting by the Fed. So far, the economy has been resilient, inflation is now contained, and thanks to overcapacity in China, deflationary forces related to goods are strong enough to offset pockets of inflationary pressures seen in labor and services. This goldilocks economic environment can be sustainable. Yes, with the Fed’s interest-rate cuts in September and November, we officially turned the page to a new chapter for US fixed-income and equity markets. But, in our view, the equity market is not beholden to further rate cuts to sustain its rally.
Earnings growth is key for continued market gains
Today, equity multiples are no longer supported by low bond yields, and the market’s current valuation is considerably above average at 24x 2024 earnings and 21x 2025 earnings.3 When stocks are expensive, earnings—and earnings growth—matter.
In the coming year, industry supply/demand forces should return to forefront, and the backdrop is changing for the 10 largest companies, which now account for about 35% of the S&P 500. In general, we anticipate a bumpier road ahead for this cohort. As we approach a new year, these businesses face a mix of headwinds and tailwinds. Sustained growth of AI infrastructure spending as well as productivity gains from AI will enhance the fundamentals of some companies. Others might be challenged by an oversupply of electric vehicles, competition in search, slowing demand for cloud computing, and a reduction in appetite for western goods sold in China. Similar to 2024, when just four of the top 10 weights in the S&P 500 meaningfully outperformed the index, we expect a wide dispersion of returns in 2025 from these giants.
What is underappreciated is that over the past 12 months, the 10 largest companies by market capitalization have accounted for all of the year’s earnings growth, meaning we have seen no growth from the other 490 stocks in aggregate.4 This arguably is a good starting point for this group. Expectations are low, and economic pressures have forced businesses to make improvements. Of course, not all will show improving fundamentals or outperform the market; most companies probably won’t. But those that can capture the upcycles should see improved earnings growth and simultaneously get rewarded with higher price-earnings multiples. This should translate to strong performance for their shares. On the contrary, when companies disappoint, their multiples will likely contract sharply.
All this points to higher volatility in the coming year. The super cycles will keep the economy chugging along, and AI should soon show up in better labor productivity numbers. While we don’t claim to have a crystal ball, if things play out as we anticipate, we believe the market could finish 2025 with a double-digit gain, helped by solid earnings growth and further-expanding multiples.5 Just like in the 1990s, however, it won’t be a smooth ride—it would be prudent to buckle up.
Endnotes
1Source: Bloomberg. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.
2The VIX index is the popular name of the Chicago Board of Exchange Volatility Index, a measure of the stock market’s expectation of volatility based on S&P 500 Index options. Often called the “fear gauge,” lower readings suggest a perceived low-risk environment, while higher readings suggest a period of higher volatility.
3Source: Bloomberg as of 10/31/24.
4Sources: IDC Pricing, IBES reported and forecast net income, S&P 500 weights and constituents as of 10/31/2024.
5There is no assurance that any estimate, forecast or projection will be realized.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. Large-capitalization companies may fall out of favor with investors based on market and economic conditions.
Fixed income securities involve interest rate, credit, inflation and reinvestment risks, and possible loss of principal. As interest rates rise, the value of fixed income securities falls. Low-rated, high-yield bonds are subject to greater price volatility, illiquidity and possibility of default.
To the extent the portfolio invests in a concentration of certain securities, regions or industries, it is subject to increased volatility. Investment strategies incorporating the identification of thematic investment opportunities, and their performance, may be negatively impacted if the investment manager does not correctly identify such opportunities or if the theme develops in an unexpected manner. Companies in the technology sector have historically been volatile due to the rapid pace of product change and development within the sector. Artificial Intelligence is subject to various risks, including, potentially rapid product obsolescence, theft, loss, or destruction of cryptographic keys, the possibility that digital asset technologies may never be fully implemented, cybersecurity risk, conflicting intellectual property claims, and inconsistent and changing regulations.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
IMPORTANT LEGAL INFORMATION
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.
Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.