Overview- After a sharp post-election rally, the broad equity market pulled back towards the end of the year and finished mixed for the 4Q. The Cap Weighted S&P 500 was up 2.5%, while the Equal Weight S&P declined -1.9%. Mid and Small cap were negative by -1% to -2%, and international was down over -7% as the rest of the world was mired in concerns over stalling economic growth. For the second year in a row the top cap-weighted 15-20 names (primarily technology) in the S&P 500 Index were responsible for about 70% of the Index return – 14.5% of the 21% price gain, while the other 480 names returned about 7-8% (Exhibit 1). This is concerning – while the promise of AI seems to be a durable trend, when the concentration in the market becomes as extreme as it is now, the market tends to struggle. (Exhibit 2).

Equally worrisome, valuations can only be characterized as full, if not expensive. As we have said numerous times in the past, valuations mean almost nothing in the short term but when P/E ratios are this elevated, forward long-term returns are rarely stellar (Exhibit 3). Finally, we are seeing signs of excessive hubris from investors (Exhibit 4). All these factors together suggest a pause in the bull market may be upon us. While the Mag 7 returns have been spectacular, historically, it has been a sign of concern for the market, rather than an expectation for continued dramatic gains.

While equity assets have generally benefited from inflation normalization in recent years, the macro backdrop is shifting. Growth is still solid, but inflation appears likely to remain sticky over the near term. While the election seemed to jumpstart a rally on expectations of favorable economic growth from a Trump administration, the Fed poured water on the fire – giving indications that the long-awaited interest rate cuts it started in Q3 of last year may come to an end this year. The market is currently only expecting one more cut for 2025. It seems the Fed is concerned over sticky inflation and a resilient economy un-bothered by their 5% rate hike cycle which ended in 2024.  This potential change in monetary status, from easing to pausing, removes a bullish pillar for the market. The Fed isn’t raising rates, so it’s not a negative, but the tailwind from lower rates is now not in the cards. The market is also unsettled trying to interpret how the impending Trump policy declarations of tariffs, immigration restrictions and deregulation will alter this interplay of rates, inflation, GDP growth and risk appetites.

Unfortunately, if rate cuts are already behind us, this diminishes the market’s ability to broaden out the rally from large cap names into areas OTHER than Technology, including mid and small caps, which was clearly evident over the last 2 weeks of the year, as smaller cap stocks are dependent on an accommodative monetary policy. We want to emphasize the characterization above as a slowdown. The bullish case rests on 2 simple tenants: bull markets rarely end in only 15 months, and this bull market has been, whether we like it or not, on a very narrow rally in tech stocks based on the AI renaissance.

While the market is flashing several warning signs, they are just that, signs that things may be slowing. The components for a bear market still seem a bit distant. After years of technology-led rallies, the S&P 500 has become so expensive that its one-year forward earnings yield has fallen to 4.6%—the same as the yield of a 5-year Treasury. This explains why equity holders are increasingly seeing bonds as competition, especially for medium-term investment horizons. These themes don’t show any signs of slowing. While valuations in tech can only be characterized as extremely rich, insanity can go on longer than most think.  Our best guess is increased volatility for 2025 as investors try to ascertain if the bull market is over for the bearish reasons we outlined above, or if it just “keeps on trucking”.

  

Conclusion- The powerful rally in equity prices in recent months leaves equities priced for perfection. While we expect equity markets to make further progress over the year as a whole — largely driven by earnings — equity markets are increasingly vulnerable to a correction driven either by further rises in bond yields and/or disappointments on growth in economic data or earnings. US equities have a favorable backdrop overall given that the Federal Reserve is in a cutting/hold cycle without the economy being in a recessionary period. However, high valuations and extreme market concentration in the S&P 500 may provide a reason for a pause.

In other words, while we remain positive on equities, the risks of near-term disappointment are rising. This helps explain why markets have been harder to please and easier to rattle in recent weeks. It’s too early to say this phase of indecisive churn is the start of anything much nastier – especially because that very churn has pulled the median stock down by almost 8% since Thanksgiving, which is the market’s way of draining elevated expectations from the price.

Exhibit 1

 Exhibit 2

 

Exhibit 3

Source: JP Morgan Asset Management

 

Exhibit 4