Will the Stock Market Experience a Downturn in 2025?
The S&P 500 (^GSPC, 0.16% decrease) is on a streak towards becoming the second consecutive year with impressive returns. With a 26.3% total return, including dividends, in 2021, it's currently up about 29% for 2022, as we speak.
This stellar performance has sparked concerns among certain analysts, who question if the market is starting to look a bit too bubbly. Even investing legend Warren Buffett has taken note, selling off some of his top assets and stockpiling cash.
Let's delve into two primary factors that could potentially impact whether the stock market plunges next year.
1. Valuation
It's undeniable that the S&P 500 is currently trading at historically significant valuations. In a recent article, Fool.com writer Sean Williams, sheds light on how the index has only reached such levels three other times since 1871, culminating in bear markets each time.
The metric in question is the Shiller price-to-earnings (P/E) ratio, or the cyclically adjusted P/E ratio (CAPE), which uses a 10-year average of inflation-adjusted earnings to smooth out economic cyclicality and earnings volatility. As of early December, the S&P's Shiller P/E ratio was at 38.8 times. While this metric has predicted two past bear markets, it's essential to remember that it's primarily a backward-looking metric, and the market typically tends to be forward-looking.
Another area to consider is the top-heaviness of the S&P 500. Companies like Apple, Nvidia, and Microsoft account for around 20% of the index, with Nvidia's earnings per share more than doubling between 2020 and 2022. Simultaneously, large S&P companies enjoy substantial earnings growth, reducing their forward price-to-earnings ratios. For example, Nvidia's trailing-12-month P/E is 56, but its forward P/E based on next year's analyst estimates is only 32.
2. Artificial Intelligence
Artificial Intelligence (AI) is a significant factor in determining whether the market maintains its strong performance or succumbs to a crash next year. While the Shiller P/E ratio might have predicted the dot-com market crash, the actual collapse was triggered by a sudden collapse in internet infrastructure spending and an abundance of unprofitable internet-based businesses.
Approximately a third of the S&P 500 is concentrated among eight companies heavily invested in AI. Despite the fact that the internet boom was spearheaded by numerous fledgling companies, today's AI boom is being dominated by major, successful companies with diversified businesses. The current growth of these companies is mainly driven by AI, which poses both opportunities and potential dangers.
If AI infrastructure spending were to suddenly collapse, as it did during the internet boom with the fall of Cisco, the market could potentially crash. However, the current AI spending is being driven by large, profitable tech companies competing to develop the best AI models. As long as this competition persists, AI infrastructure spending should continue to grow, which is beneficial for companies like Nvidia and, by extension, the S&P.
To advance AI models, these companies require exponentially more computing power and AI infrastructure spending. To maintain this growth, larger tech companies, such as Amazon, Microsoft, and Alphabet, need to see strong growth from their AI divisions. The software industry is now experiencing increased AI-related growth, with tech companies aiming to save costs and create efficiencies for their customers, extending beyond the tech sector.
Overall, the market's current valuation and its reliance on AI for continued growth present potential vulnerabilities. However, given the market's historical average bull market duration of around 5 1/2 years, and its current position two years into the current cycle, the market might still have room to continue its strong run. But investors should remain cautious and closely monitor these factors for any potential market corrections or even a crash in the near future.
[1] S&P Dive: A decade-long forecast of stock market returns, Jan 13, 2022, by[2] Burton Malkiel's A Random Walk Down Wall Street, 2021[3] Newport Beach Wealth Management, The Shiller CAPE Ratio, No Date[4] Richard Bernstein Advisors, The Shiller P/E Ratio, No Date
The concerns about the S&P 500's performance leading to potential market corrections or even a crash next year highlight the importance of careful financial management for investors. In light of this, individuals should consider diversifying their investments and reviewing their financial strategies, including their approach to investing money.
As the text emphasizes, the S&P 500 is currently trading at historically significant valuations, which could potentially put it at risk if the market were to take a downturn. This highlights the significance of analyzing financial data and making informed decisions based on market trends and industry forecasts, such as the Shiller price-to-earnings (P/E) ratio and the top-heaviness of the S&P 500.
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