myICLUB Blog

After two great years in the equity market, 2025 got off to another strong start with the S&P 500 making record highs driven by earnings growth and non-Magnificent 7 stocks. Valuations are stretched, and there are other signs of froth in the market, arguing for caution. The economy is on solid footing with moderate employment gains and continued economic growth. However, inflation remains higher than the Federal Reserve’s 2% target and the Fed anticipates only a half percentage-point reduction in the Federal Funds rate this year. Long-term rates remain about where we entered the year. Their direction from here will be a function of inflation and government borrowing requirements as the new administration implements its tariff and fiscal policies.

Year to date the S&P 500 is up 4.2%. But in a change, the Magnificent 7, about a third of the index, has lagged while the other 493 stocks have powered the gain. Excitement for Artificial Intelligence continues to drive the market and its impact was visibly seen on January 27th when DeepSeek, a Chinese AI firm, reported using older Nvidia chips to train AI models at a fraction of the cost of current methods. Nvidia, the leading AI chipmaker and stock powering the AI revolution, dropped 17% on the news. Since the announcement Nvidia has recovered most of this drop as investors were soothed by the increasing capital expenditure plans from other Magnificent 7 members Microsoft, Alphabet, Amazon, and Meta Platforms. However, except for Meta these “Cloud Titans” have seen their shares struggle as investors stomach these massive spending plans while worrying that revenue from AI won’t fully justify them.

With the Magnificent 7 taking a breather the market is being driven by earnings. FactSet’s Earnings Insight, compiled by John Butters, calculates that fourth quarter earnings have advanced 16.9% for the 77% of companies in the S&P 500 that have reported. The advance is broad-based, as six of the nine sectors in the index have reported double-digit growth. If this growth rate holds the quarter will mark the highest year-over-year earnings growth rate since the fourth quarter of 2021.

As long as earnings stay robust the market should be able to advance, but valuations are stretched and there are signs of speculation. Analysts expect first quarter earnings growth to slow to 8.1% while steadily building as the year progresses, finishing the full year 2025 at 12.7% growth. They are even more bullish for 2026, expecting a 13.9% advance. Even with a strong quarterly finish to 2024, the 2025 forward P/E ratio of the S&P 500 has risen to 22.2, 12% above the 5-year average of 19.8 and 21% above the 10-year average of 18.3. This valuation level isn’t that far below the 26 achieved in 2000 before the dot-com crash. Further, in addition to AI excitement, Bitcoin has reached all time-highs, options trading in January reached 58 million contracts, a monthly record dating back to 1973, and former meme stocks GameStop, Blackberry and Chewy have almost doubled over the past year. Investors are turning cautious as the American Association of Individual Investors reports that 47.3% of membership expect the market to fall over the next six months, the highest level since November 2023. Usually, a bearish attitude is a contrarian indicator, but in this case elevated market levels warrant caution.

Stocks continue to thrive because the economy is on a solid growth path, featuring moderate employment growth and the expectation that inflation will continue to fall. Fourth quarter GDP grew 2.3% and January saw 143,000 new jobs created with the unemployment rate declining to 4.0%. For the week through February 8th jobless claims fell to 213,000, down from 220,000 a week earlier, and the number of continuing claims fell to 1.85 million from 1.89 million. Employment gains drive wages which provide the cash flow for consumers to spend, signaling that the risk of recession is low.

However, consumers and businesses are becoming more cautious due to still-stubborn inflation. January retail sales declined 0.9% from December but were up 4.2% over last year. Weather likely played a role as the south was unseasonably cold, but inflation continues to strain lower income consumers. January saw the consumer price index jump 0.5%, the largest monthly increase since August 2023. Egg prices rose more than 15% from December due to the bird flu outbreak, accounting for about two-thirds of the total monthly increase in grocery prices. Core prices, which strip out volatile food and energy prices, rose 0.4% from December. Year over year core prices rose 3.3%, right in the middle of the 3.2%-3.4% range that has prevailed for the past nine months. While some economists believe seasonal factors in January might have boosted the reading, inflation appears sticky at +3%, higher than the Federal Reserve’s 2% goal.

Policy changes introduced by the Trump administration, particularly on tariffs, are also rattling consumers. Consumer sentiment fell about 5% in the University of Michigan survey in early February and expectations of inflation in the year ahead jumped a full percentage point to 4.3% from 3.3%. The jump is due to consumers expecting tariffs to increase prices. Consumer expectations of inflation are a key factor used by the Federal Reserve to set monetary policy and the Fed would prefer to see inflation expectations remain anchored rather than drift higher.

At a recent quote of 4.57% the 10-year treasury yield is roughly flat for 2025 after increasing in early January due to the higher inflation reading than expected. In late January the Federal Reserve announced it was holding the federal funds rate between 4.25%-4.5%, a move that markets anticipated after the inflation report. The Fed projects cutting rates by about 0.5% in 2025 and the market expects the first cut mid-year. However, if inflation reaccelerates or even just stabilizes at around 3% the Fed might be forced to pursue rate increases, a significantly different outcome than markets expect.

Tariff and tax policies being pursued by the Trump Administration and Republicans will also have an impact on the direction of interest rates. Tariff policies have been a moving target as Mr. Trump contemplates their use to generate negotiating leverage, pursue industrial policy objectives, and bring in new revenue. The Senate and House are working on two different reconciliation bills, with the House pursuing extension of the 2017 tax cuts and additional military and border spending while the Senate focuses on a smaller bill that only pursues spending. With the U.S. running a budget deficit eclipsing $2 trillion per year and debt service exceeding all nondefense discretionary spending, markets would like to see some progress on reducing the deficit to support lower future rates.

Equity market valuations are stretched, and interest rates are historically normal. The economy is doing well, but inflation is higher than the Federal Reserve would like, and the new administration has introduced uncertainty that investors hope will clear up as new policies are put in place. Regardless of the environment, successful long-term investors focus on finding and holding companies that generate consistent earnings growth and are reasonably priced.

In the March 2025 issue of the Investor Advisory Service newsletter, our analysts introduce a midsized sports and entertainment business with expiring broadcast contracts that could drive growth significantly upon renewal, as well as an IT firm supported by federal military contracts and other spending that looks positioned to survive and thrive even with current restructuring efforts.

The commentary is excerpted from the issue of the Investor Advisory Service newsletter published at the end of February. To receive commentary like this in a more timely matter and receive actionable stock ideas each and every month, subscribe today.

The Investor Advisory Service stock newsletter was named to the Hulbert Investment Newsletter Honor Roll for the 15th consecutive year for outperforming every up and down market cycle since 2007. For more information about the Investor Advisory Service, to download a sample issue, or to subscribe to the one of the top investing newsletter in the U.S. for long-term consistent returns, visit Investor Advisory Service.