American Moment - can US stocks keep powering on from here?

US equity returns have been disproportionate by long run standards. Economic fundamentals remain sound but market valuations are stretched. And, for investors, the start of the new Trump administration will matter – to a point.

30 January 2025

The US equity market piled on a cool 25% in 2024 as measured by the S&P 500 Index in US dollar terms*. For context, Siegel’s Constant – a measure developed by economist Jeremy Siegel as a guide to potential long-term stock market returns after allowing for inflation - has observed a real return in US stocks of 7% on an annualised basis since the 19th century¹. Recent gains therefore feel frothy, even when one considers the last five calendar years when the S&P 500 produced an annualised return of ‘just’ 14.5%*, over double Professor Siegel’s long observed run rate. The burning issue for investors is therefore whether these recent returns, or even just positive ones, can be sustained into the short-to-medium term. Coming to any reasonable conclusion on this point involves not just an evaluation of US economic fundamentals but also a take on stock market valuations and a calm assessment of what could happen in the opening months of the incoming Trump administration.

The US economy is in good shape

First, the economic fundamentals. These are undoubtedly strong. The US economy has been growing at a rate of just over 3%* per year and, according to a Bloomberg survey of economists, is expected to grow by around 2% in 2025*. In December alone, the economy added fully 256,000 jobs*. Unsurprisingly, the all-important US consumer is happy with their lot, with retail sales up nearly 4%* in December on the previous 12 months, while wages are up circa 4%* over the same period versus headline inflation of 2.9%*, suggesting a real wage gain of 1.1% for the average US worker over the last year. The stock market of course benefits directly from a stronger economy, with earnings clearly linked to economic activity, as one would expect. But there are other tailwinds behind stocks too.

The AI effect: transformative and still compelling

The artificial intelligence (AI) revolution is driving not just earnings now but expectations of further earnings into the foreseeable future. On 7th January, US chip designer Nvidia offered a wide-ranging and frankly spellbinding long-term vision of how AI would percolate through the economy, outlining a future world with a billion humanoid robots, ten million automated factories and one and a half billion self-driving cars and trucks² . Interest in AI-related chips has boomed as firms across the world invest in AI equipment to streamline and automate their product offerings. The opportunity for corporations is significant. According to a report published by IBM in January³, “Retail and consumer product companies are at a tipping point where embedding AI across their operations can help define not just productivity gains but the future of brand relevance, engagement and trust.” The technology consulting firm also revealed in a survey that such firms are allocating an average of 3.3% of their revenue to AI. Little wonder then that the so-called Magnificent Seven technology stocks (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, Tesla) which are enabling AI have been crushing all before them, including even the oil drillers that should in theory have been supported by Trump 2.0’s latest “Drill baby, drill” mantra. Chinese AI upstart DeepSeek may have rattled cages with its new open-source AI model but if anything this was indicative of falling costs which the US firms should also benefit from. Regardless, in the outperformance of the AI superscalers over the last year perhaps lies a lesson on avoiding investment according to politically-driven equity sector preferences.

Crushing not drilling - Magnificent Seven driven by fundamentals rather than politics:

From 29 Dec 2023 to 16 Jan 2025

But more on that later. Another risk to continued progress in US stocks today is surely the current state of investor sentiment and valuation.

Investors have gone all in on the US

The stock market feels subjectively frothy and a brief overview of market surveys and metrics is informative. Firstly, from a technical positioning perspective optimism abounds and bearishness is the exception rather than the rule. The Conference Board’s stock price expectations survey reveals euphoric sentiment, showing that households are the most confident they have ever been that stocks will rise over the next 12 months*. Additionally, Bank of America’s respected fund manager survey shows that professional investors are the most overweight US stocks they have been in just over a decade. This could potentially lead to market volatility if anything goes wrong with the narrative that got the market to where it is today, and indeed it did temporarily when the aforementioned DeepSeek revealed its new AI product. Turning to valuation metrics, they look elevated. One compelling such measure is the equity risk premium (ERP), which as the name suggests spells out how much more (or less) equities yield versus bonds. The forward Price/earnings ratio of the S&P 500 stands at just 4.0% as of 28 January*. Compare with 4.6% for the US Treasury yield*, and it is clear that equities are more expensive than bonds, barring unanticipated upward moves in price and / or earnings in the future. Another respected valuation measure is the Shiller cyclically-adjusted price earnings (CAPE) ratio, which measures the ratio of price over the past ten years of inflation-adjusted corporate earnings. This measure now stands at 37x as of 2 January*, the third highest it has been since at least the end of the 1970s (the other two peaks were amid the late 1990s dot.com bubble and the post-pandemic equity bounce in late 2021). While valuation alone does not determine what happens tomorrow, elevated valuations will surely add to the vulnerability described above.

CAPE of Good Hope? Shiller’s famous valuation measure hardly shouts ‘bargain’:

Data for S&P 500 from 31 Jan 1979 to 02 Jan 2025

Whether the favourable economic and market dynamics or stretched valuations and positioning ‘win’ from here could well depend on how the new Trump administration’s legislative programme pans out. The optimistic scenario rests on successfully renewed personal and business tax cuts, along with deregulation. Keeping taxes low will be helpful for corporate margins while doing something about the 100,000+ page United States Code of Federal Regulations⁴ should also keep costs down for businesses and lower barriers to entry for new firms, thereby encouraging innovation and productivity. If all this is realised then investors may yet set aside the issue of market valuation.

What are the risks from here?

But inflation makes a case for being the main consequence of any policy error under the new administration. It was arguably the very reason the Democrats were unable to secure a second term. Too much stimulus for an economy already coming off the back of a previous round in the form of the CHIPS Act, which aims to boost US semiconductor manufacturing and innovation, and the IRA Act, which targets reducing the federal deficits, lowering prices of prescription drugs and investing in clean energy - as well as pandemic payments - could fuel inflation’s second wave. More specifically, the nativism that propelled much of the Trump campaign threatens to starve America of crucial workers. The 11 million or so undocumented migrants⁵ living in America today mostly work in services and hospitality, performing jobs that most American-born workers are not interested in filling.

At the other end of the scale, ending the H-1B visa programme would deprive key US sectors such as IT of around 85,000 highly skilled entrants per year⁶. Removing both sets of workers would surely raise costs across the economy while also eroding America’s unique edge in the global war for talent (The Economist newspaper describes H-1B as the country’s “exorbitant privilege”). Taking Trump seriously but not literally is too general a guide to what will happen, especially given that there is an informative first term to refer to. While the wall to separate Mexico never happened, no less unimaginable policies such as trade tariffs did. So this time, the more economically unappealing campaign promises should be treated as real risks to a richly valued market which nearly everyone now appears to believe in. But some comfort can still be drawn from the aforementioned Magnificent Seven’s strong outperformance of oil service companies in recent months. This suggests that if the Trump programme proves less positive than many assume, investors can still lean on positive economic and market drivers that are the envy of the world, even if they are occasionally challenged, as they inevitably will be. Which leads to another fairly reassuring conclusion. The question of what will happen next to US equities is frequently framed as a choice between a continuation of strong returns, or an outright correction. But there is a third potential outcome – returns which are simply more in line with their long-run history. Which wouldn’t be so bad after all.

Julian Howard is Chief Multi-Asset Investment Strategist at GAM Investments.