Last week, investors watched good news become bad news, as a stronger-than-expected jobs report sparked a market dip.
The market’s fears, of course, are that such a strong jobs picture gives the Fed even less leeway to cut interest rates further. Long-term interest rates ticked up that same day, with the yield on 10-year Treasurys climbing increasingly close to that 5% mark that has spooked stocks in recent past years.
While I continue to believe we are in a bull market—with rising earnings poised to pull the weight of the market still higher—this recent volatility could be a sign of things to come. Later stages of a bull market tend to be more volatile. And it doesn’t take as much to disrupt the market’s mojo when valuations like price-earnings (PE) ratios are high, as they have been. But moreover, I believe the interest-rate angst that’s been weighing on the market isn’t likely to go away anytime soon, and could be a recurring feature of the year ahead.
Here's a look at some of the trends that have caught my eye since the start of the year.
The broadening runs out of breadth
One of the big market stories in the second half of 2024 was the broadening, as market leadership seemed finally to pass from the “Magnificent 7” to the rest of the market, with a wide and varied range of stocks finally participating in and driving broad market gains.
Yet since mid-December (around when the Fed came out with reduced expectations for further rate cuts in 2025), the market has experienced a notable loss of momentum and breadth. As of last week, only 24% of stocks were trading above their 50-day moving average, and only 29% of S&P 500® stocks were outperforming the index. This was not what investors wanted to be seeing.
One question this poses for investors is whether those narrow leadership trends could continue for yet another year. Given that trends in motion tend to stay in motion, the most likely answer might be “yes.” That said, these trends have been in motion for quite some time now—with large-cap growth stocks at the top of the 5-year-growth-rate leaderboard for the better part of the past decade.
At some point, mean reversion (the tendency for asset prices to return to their long-term trends over time) should kick in, and when it does it could be fierce. But when and from what level remains an elusive question. Timing tops and bottoms is always a low-success-rate undertaking, and in the case of the Magnificent 7 it has been especially so. To borrow a saying from the legendary former Fidelity fund manager Peter Lynch, selling your winners too soon can be “like cutting the flowers and watering the weeds.”
All about the rates
Back to last week’s volatility, Friday’s employment data confirmed that the economy remains strong and the labor market remains tight. This allows less room, if any, for the Fed to cut rates, and the market is now pricing in only one additional rate cut for this cutting cycle. Personally, I would not be surprised if the Fed is done easing.
At the same time, the yield curve has been steepening (meaning the difference between long-term rates and short-term rates has been widening), as 10-year Treasury yields have been rising.
This increase has seemed to be coming from a rise in the “term premium,” which refers to the additional compensation that lenders, like bondholders, typically require for lending for longer periods. After an unusual decade of negative term premiums—largely due to quantitative easing and zero or near-zero interest rates—it makes sense that this premium might start reverting to a more normal level, such as 1 to 1.5 percentage points.
Why is the stock market now so sensitive to these changes? There are times when the stock market doesn’t pay too much attention to rates. But in periods of relatively high inflation, stocks and bonds tend to become positively correlated. One market model that has often worked in such periods is the “Fed model.” This theory holds that the interest rate on 10-year Treasurys and the earnings yield on stocks (meaning, earnings divided by price) should be roughly equivalent—or at least correlated—as investors pursue the highest yields.
Before the rate-induced bear market in 2022, 10-year Treasurys were 91% more expensive than stocks, according to this model, which left some cushion for stocks to do their own thing. But now, Treasurys are 15% cheaper than stocks on this measure, even though Treasurys are the lower-risk investment.
In short, given that valuation picture—plus the possibility that the term premium (and long yields along with it) might keep rising from here—I think this sensitivity to long interest rates could continue, and cause more stock-market angst in 2025.
Watching for earnings growth to show up
All of that said, as I mentioned at the start, I believe rising earnings may help to soften some of these pressures, and could pull the market higher yet.
Fourth-quarter earnings season is just beginning, with consensus analyst expectations of 7% growth. If results follow a typical pattern of beating estimates, it could make for another double-digit quarter, which would help to dampen those valuation pressures.
While 2024 was a Goldilocks year of rising earnings and rising valuations, this year might see those forces pit against each other—with earnings growing but rising long-term rates pressuring valuations.
The main question for 2025 is where the opposing forces of growing earnings and rising rates may lead the market.
