Will 2025's U.S. Stock Market Live Up to the Hype

Why Earnings Growth Matters More than Ever

With earnings season kicking off this week, it is an opportune time to highlight the significance of earnings growth in 2025. Earnings trends are a critical ingredient of stock returns and earnings growth has been very strong in the U.S., driving the S&P 500 Index to fresh highs. Valuation is also a critically important component of stock returns and over the past two years, a key driver of strong returns has been the increase in price-to-earnings multiples, reflecting the higher prices investors are willing to pay for earnings. As a consequence, we begin the year with historically high U.S. stock valuations along with above average earnings growth expectations. This combination of elevated P/E multiples and optimistic growth expectations suggests that this year’s equity returns will likely hinge on earnings more than normal, absent some unanticipated geopolitical impact.

To understand why earnings growth is more critical today, we need to zoom out a little and consider recent market activity for context. The U.S. equity market is coming off two years of very strong performance. For only the 9th time in the past 75 years, returns from the S&P 500 Index exceeded 20% for two consecutive years. While the fear may be that the market is due for some sort of correction after a strong consecutive year, a historical study of market returns suggests that a third year of positive equity returns is entirely possible. As the below graphic demonstrates, a third year of positive S&P 500 Index returns followed consecutive 20%+ returns more often than not.

Graphic 1: Back-to-Back 20% Gainers

These strong recent returns were achieved through earnings growth, particularly among the Mag 7 stocks that have driven much of the top-heavy returns in the U.S. equity market, as well as increasingly higher valuations that investors are willing to pay to own equities. In 2024, the pace of earnings and valuation growth both exceeded 10%. This confluence of sharply increasing earnings and valuation growth is relatively rare. The only other recent years when this happened were 1997 and 2003. Combined with moderating inflation and continued economic expansion, this “goldilocks” investment environment set 2024 apart and can explain the strong performance of equities in the U.S.

Graphic 2: P/E and EPS By Year

Over the past year, earnings growth has been concentrated among the mega-cap stocks, which have been the primary focus of investors the past 18 months. As illustrated in the graphic below from BlackRock, trailing earnings growth for the Mag 7 stocks is a whopping 45%. While analysts anticipate the Mag 7 names to sustain strong earnings growth into 2025, the pace of growth is anticipated to moderate to 18%. Looking forward, analysts anticipate growth to pick up more broadly, especially among small cap and emerging market stocks.

Graphic 3: Earnings Growth and Forward Expectations

With these forecasted earnings in mind along with receding recession fears among economists, year-end 2025 price targets for the S&P 500 Index are rosy. Nearly every major investment bank and research provider expects 10% or higher returns for U.S. large caps. If we are focused on earnings, these bullish price targets seem logical. After all, 14% forward growth projection for U.S. equities as noted in the above graphic from BlackRock is well above historical trend lines and--absent a decline in valuations--bullish.

Graphic 4: Forecasts for 2025 Stocks

Yet valuation cannot be ignored. When valuations are high on a relative and historical basis, everything must go just right to achieve this year’s end targets. We begin the year in this situation. The U.S. stock market is valued by investors at levels seldom seen. The forward P/E for the U.S. stock market is above its 90th percentile range, as the graphic from Goldman Sachs illustrates. Even stripping out the mega cap technology companies, valuations are historically high in the U.S.. No other equity market in the world is trading at similar earnings multiples.

Graphic 5: Valuations 4Q24

The impact of growing earnings can be easily undermined when valuations fall. If there is a growth scare, real or perceived, investors may not be willing to own U.S. equities at these rich valuations. The solace is that above average earnings growth, especially in a period of accommodative Fed policy, encourages multiples to increase as we have recently witnessed. Periods of strong earnings growth rarely coincide with declining valuations. In fact, in a historical analysis by Morgan Stanley, S&P 500 Index valuation remains the same or rises 91% of the time when earnings growth is above average (6%+) and the FOMC is cutting rates. Thus a logical conclusion is that as long as earnings growth proceeds as well as analysts predict, high valuations will remain intact.

Graphic 6: Earnings Growth Impact on Multiples

The secret to happiness, many have argued, is lowered expectations. High expectations, such as those at the start of 2025 in the U.S. stock market, can be a recipe for a letdown. If valuations were lower, the U.S. stock market would have more of a buffer to absorb disappointment. Yet they are not, and therefore sustained earnings growth will be more essential than ever in 2025.

Therefore risks headed into the year appear to be asymmetrical: a growth surprise to the downside will likely have a more substantive impact on stock prices than a surprise to the upside. Beware of growth scares and the resulting impact on valuations.

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