myICLUB Blog

With 2024 winding down, markets are primed for Santa Claus to deliver a stock rally in the final days of December and first days of January.

Small-caps will not see enough of an uplift in the last few days of the year to match the returns of mega-cap tech stocks, but should gain enough altitude to come out ahead of the small-cap index’s long-term averages.

While the market unquestionably has not fallen head over heels about the Fed’s new “higher for longer” interest rate stance, recent data about inflation and personal consumption has been better than expected, giving support for the market’s year-end run. Excluding food and energy, the Commerce Department’s core personal consumption expenditures (PCE) price index edged up by just 0.1% in November after climbing 0.3% in October. Economists had expected core prices to rise by 0.2%.

The environment for this year’s all-important holiday shopping period is difficult. Comparisons to 2023 will be tough as this year’s season has just 27 shopping days between Thanksgiving and Christmas compared to 32 last year.

Online spending continues to grow, with pre-Christmas holiday season e-commerce spending up 6.7% over 2023. Bricks-and-mortar stores continue to be tested, with same-store sales up just 2.9% over last year.

Retailers, especially discount stores, are still feeling the pressures of addressing behaviors of lower-income customers. Despite wage gains and high employment, these consumers continue to hold back on their spending. Retailers are pushing price cuts and increasing promotional activity in order to drive sales. Their efforts may keep revenue growth steady, but margins and thus earnings will certainly be negatively pressured.

Sadly, retailers along with broad swaths of the economy will likely face greater challenges in 2025.

My sanguine outlook on the economy of the last several years has been replaced with concerns about how businesses will fare in a much-changed landscape that includes tariffs, slashed government spending, mass deportations, tax cuts that disproportionately impact low-income citizens, deregulation, and a general morass of inchoate policy messaging from the White House.

The Federal Reserve’s recent rate cut (the third reduction of 2024) was long expected, but the Fed’s signal that it only expects two 25-basis point reductions in 2025 came as a surprise.

Homebuilding and Home-Buying

One unlikely beneficiary of higher future interest rates may be the homebuilding and construction industries. Many homebuyers have been in the dugout waiting for mortgage rates to come down, and with borrowing costs now looking to remain in the same ballpark for some time, these buyers are now stepping up to the plate.

November’s new home sales surged by 5.9% according to the Department of Commerce, with the National Association of Realtors reporting that existing home sales spiked by 4.8% in the month.

How long the homebuying spree will last is open to consideration. Home prices are already at record highs, so increased material and labor costs that will likely result from trade tariffs and aggressive immigration policy actions could impede affordability and thwart many homebuyers later in the 2025 year despite the chronic lack of housing supply and accompanying high demand.

Tariff Terrors

Many of the cheerleaders for increased trade tariffs are seemingly unaware that tariffs on imported goods are paid by American businesses, not by foreign governments. Somewhat inexplicably, the Conference Board reported that only 46% of US consumers expect tariffs to raise the cost of living while 21% expected tariffs to create more US jobs, a result that even if achievable in the near-term begs the question, “who exactly will fill those jobs?”

Virtually every economist will agree that tariffs almost always lead to Americans paying higher prices on goods, from either paying more for imported goods or from paying more for domestically-sourced alternatives.

Though it remains to be seen how the scope and depth of widespread tariffs will ravage American businesses in the coming year, prudent investors should view the scenario of returning inflation and severe margin and earnings pressures as a very distinct possibility.

Companies like Wal-Mart, Target, Dollar General, and Five Below have been grappling with costs of goods, and it is difficult to see how restrictions on Asian imports is going to have anything but a detrimental impact on the bottom lines of these retailers. In turn, higher prices may well keep the spending of lower-income consumers in check, further pressuring top line results.

Consumers Are Not Confident

Consumer confidence surveys remain difficult to interpret. The University of Michigan’s consumer sentiment survey showed that while consumers in November and December recognized that inflation has slowed and the economy has improved, their outlook remains decidedly tempered. The University’s “Survey of Consumers” Director Joanne Hsu explained that consumers “do not feel that they are thriving.”

The Conference Board’s Consumer Confidence Index reported an 8.1 point decline in December to 104.7. Its Present Situation Index, based on consumers’ assessment of current business and labor market conditions, fell 1.2 points to 140.2. More worryingly, their Expectations Index, based on consumers’ short-term outlook for income, business, and labor market conditions, tumbled 12.6 points to 81.1. When this index falls below 80, it indicates that a recession is ahead.

Consumers are resilient, but their actions speak louder than their opinions. Wallets and pocketbooks are open right now, even though people anticipate that they will not make any major purchases in the first half of 2025.

The Dilemma of a Strong Dollar

The dollar fared well in 2024, up around 7% compared to a basket of peers. Economic growth and rising Treasury yields should continue to support the greenback in 2025, with protectionist trade policies possibly delivering a further boost.

The dollar’s position in the global economy, though, complicates prospects for interest rate cuts from other central banks, which would lift the dollar, while a strong dollar could hold back results for U.S. multinationals and foreign companies after converting their results to dollars.

The Best, Worst, Most Confusing of Times

For the broader economy, if inflation remains reasonably tame, and interest rates hold tight, neither American businesses nor consumers might face doomsday in 2025.

Low unemployment, plenty of  job openings, and healthy cash flows and corporate profits will give U.S. businesses a running start in 2025, but the fastest thoroughbreds during dry conditions often have trouble navigating muddy courses.

No Clarity for Stocks

The outlook for stocks in 2025 is murky.

Aside from the impact of AI on business activities and the dominance of mega-cap tech stocks, valuations remain a major concern. The S&P 500’s current trailing P/E ratio is 30.83, the highest multiple of any non-outlier period since the peak of the 1990s bull market in 1999.

The S&P 500 reached 56 new highs in 2024, which is often the case at the start of bull markets. However, according to Charles Schwab, when the number of record highs exceeded 35, the S&P 500's median gain in the following year was just 5.8%.

An awful lot of optimism is built into the market’s current valuation, and history teaches that it is often calmest before a storm. The chance that the market continues to move higher in 2025 is substantial, as valuation itself is a not an indicator of future potential returns. But right now, there are more budding triggers in place that could spark a major market event than at any point in at least the last decade.

While this doesn’t suggest that investors should avoid stocks, it does point to the importance of stock picking, portfolio management, diversification principles, and downside protection from hypervalued shares.

Defensive stocks could become even more popular in 2025, while traditional cyclical stocks continue to face headwinds and economically sensitive stocks, especially large- and mega-caps, remain market darlings.

The importance of diversification, especially to combat megastockfluenza (the ailment that arises from blind love for large companies), should grow in 2025, with individual stock picking remaining a key tactic for navigating the risk/return minefield of the coming year.

Will Patient Small-Cap Investors Finally Be Rewarded?

For small-caps, one of the major restraining factors to their performance has been higher interest rates.

Conventional wisdom says that higher borrowing costs are an anathema to small company fundamentals. By association, even small company stocks with no debt get lumped together with their cash-poor and highly-leveraged brethren, and this whole market component is curtailed as a result.

With interest rates locked in to current levels for the foreseeable future, this viewpoint is not likely to be changed any time soon.

On the positive note, small-caps tend to be more domestically-focused than large-caps, so many of them will be able to continue delivering profits despite trade restrictions. Companies in the Russell 2000 usually earn 80% of their revenues from domestic operations, while S&P 500 companies on average earn less than half of their revenues from within the U.S.

As long as the economy delivers, small-caps should hold up well, and perhaps outperform large-caps.

According to CFRA, stocks in the S&P 500 are currently forecast to generate 13% EPS growth in 2025 and 13.1% growth in 2026 (versus estimated 8.5% EPS growth in 2025), while the S&P SmallCap 600 is expected to EPS growth of 20.9% in 2025 and 18.6% EPS growth in 2026 (versus an estimated -8.0% in 2024),

Some small-cap bulls point to the broadening bull market which usually expands to include smaller stocks at this point in the cycle (if history is any guide). As market valuations for large- and mega-caps remain stretched, the relative bargains available in small-caps should become more appealing.

CFRA research shows that the S&P 500 is currently trading at 22.9 times forward 12-month EPS estimates compared to a 10-year average of 19.0x. On the other hand, the S&P SmallCap 600 currently sits at 18.1x forward 12-month EPS estimates versus a 10-year average of 18.7x.

It is not at all inconceivable that the much discounted valuations of small-caps could well cross over the much extended valuations of large-caps at some point in 2025.

As always, though, a focus on company quality should be maintained when selecting small-cap stocks.

Our focus stock in this issue is a high-quality small property and casualty insurance company with a claim as one of the largest providers in its major niche market.

Stay the course!

• DOUG GERLACH

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the January 2025 issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 45 high-quality small company stocks currently covered in the newsletter.