January 2025 Market Update
U.S. Equities recovered from December’s losses and a turbulent start to the month, ultimately achieving solid gains, with the S&P 500 gaining 2.7% in January. A sharp increase in interest rates, uncertainty around the new administration’s policies and questions about the outlook for Fed rate cuts all contributed to elevated volatility and share price declines early in the month. Milder than expected December inflation and a strong start to 1st quarter earnings reporting season (led by the Banks) helped turn the tide into the back half of January. Markets took further encouragement from the surge in December Housing activity and strong Retail Sales during the holiday shopping season. Developments coming out of Washington around Inauguration Day were generally seen as constructive as investors specifically focused on the growth impacts of a de-regulatory agenda. Meanwhile, trade tariff policy – its scope, degree, and duration – will be a focus point and may be a significant driver of volatility over the coming months.
DeepSeek AI’s Impact on U.S. Stocks
Headlines around the emergence of China's highly advanced and supposedly lower-cost DeepSeek AI model challenged investor assumptions around the Artificial Intelligence (AI) growth narrative. The development drove a sharp sell-off in Tech and Energy stocks associated with the AI theme despite many unanswered questions about the veracity of cost and computing power claims made by the team responsible for the release. Regardless, the news does raise fresh questions about the tidal wave of AI investments made by U.S. Tech firms, how much pricing power they can maintain in the future, and the level of returns they can expect to generate off today’s investments. The size of one-day declines in some AI related stocks may appear overdone, but it is also important to highlight the role that stretched valuations and crowded investor positioning in these names may have played in the adverse market response. The sell-off perhaps provides a timely reminder of the risks inherent within a narrow market dominated by just a handful of stocks or when a certain buy thesis seems infallible.
Potential Broadening and Rotation in Equity Markets
The disparate impact observed across different market sectors in reaction to DeepSeek AI headlines was difficult to ignore. Sectors like Tech, Energy, and Utilities (all beneficiaries of the AI trade to date) struggled mightily as the S&P dropped 1.5% in a single day, while more than half of S&P 500 sectors and nearly 70% of stocks included in the index traded higher. This unusual dynamic suggests investors are at least contemplating the possibility that accelerating AI cost deflation might make it easier for more traditional companies to deploy AI internally and realize productivity benefits which boost profit margins, potentially at the expense of today’s established “AI winners”.
Perhaps investors are just looking for other ideas. The performance of the S&P 500 has been primarily driven by a narrow handful of Tech stocks for much of the past two years. We view a broadening of returns and increased participation from other corners of the market as a healthy development, particularly for well diversified portfolios. Notably, the Equal Weight S&P index – representing returns for the “average” stock – rose 3.4% in January and outperformed the market cap weighted index by over 0.7% this month. This may signal a resumption of the broadening trend observed between July and November of 2024 and a reversal of the extremely narrow market performance seen in December. Some investors may be surprised to hear that Technology was the only S&P 500 sector with negative returns in January!
Beyond a potential shift away from the one-sided and potentially unsustainable euphoric sentiment driving select technology names, there exist fundamental and valuation-based underpinnings for a more protracted change in investor preferences. Last year witnessed a significant gap between Magnificent 7 (Mag 7) earnings growth and that of the “average stock.” Analysts expect this margin to narrow in 2025, with consensus estimates calling for the “average stock” to see earnings accelerate while Mag 7 growth moderates from extremely high to merely strong levels. Combining actual results and estimates, 4th quarter earnings growth for the S&P 500 index is now expected at 13.2%. If true, it would be the highest year-over-year growth rate since the 4th Quarter of 2021. If estimated growth rates do converge, it may become more difficult to justify the valuation discount observed in most of the rest of the market compared to Mag 7 stocks.
Similarly, a broadening of earnings growth may offer support to certain sectors that have struggled recently. Underperformance has left certain S&P 500 sectors like Energy, Financials, and Healthcare contributing a higher percentage S&P 500 earnings today than their corresponding market cap weight would suggest (with the opposite being true of the Tech sector and the Mag 7 stocks more specifically). Similar fundamental “under-punching” versus their index weights has historically been a precursor to better sector returns. Additionally, broader participation in earnings growth across the entire market would certainly make these dynamics more difficult to ignore.
Market Impacts of a U.S. Election Cycle
It is also important to remember that markets often price in expected election impacts by the February of a President’s first year. Additional positive or negative momentum cannot be ruled out as the new administration gets to work, but sectors and stocks that have been punished or rewarded relative to the S&P 500 in recent months may already have a policy outlook reflected in their current prices. We suggest investors remain focused on earnings and valuations and avoid trying to game sectors or stocks based on perceived effects of a new administration’s policy objectives. President Trump’s first term saw numerous trades “work” initially, only to eventually unwind as circumstances evolved, including those well beyond the control of the government or the White House.
Overall, the first year of a Presidency historically tends to be positive for stock returns. However, past political cycles also suggest the first few months can be volatile, with significant swings in either direction possible as investors absorb new policies and gauge economic impacts. While recent “first years in office” have been very strong, we caution investors to recall the context around each data point and observe differences versus today’s climate – in 2009 the US was emerging from the Financial Crisis, 2013 came after the European Union debt crisis, 2017 followed a domestic manufacturing recession, and 2021 was the recovery from Covid shutdowns. The bar is quite a bit higher this time around following back-to-back 25% annual gains for the S&P 500, with valuations higher today than prior inauguration years.
While uncertainty and volatility are expected with a significant change in government, investors should try to differentiate between volatility and risk. Price volatility can certainly morph into permanent loss of capital in certain instances, but most of the time it only does so when investors succumb to their emotions. More often, such swings create opportunity for longer term, patient investors.
Interest Rates and Fed Outlook
Elsewhere, the Federal Reserve (Fed) held the policy rate steady at their January meeting, as expected. Recent rate cuts have moved monetary policy from excessively restrictive toward a more balanced position, and expectations for additional 2025 rate cuts have moderated on the back of economic data pointing to a stable labor market and resilient U.S. consumer. While the Fed is likely to pause for some time and move slowly from there, constructive inflation trends (particularly in shelter costs) would allow them room to support markets should any pronounced economic weakness materialize. The trajectory of incoming inflation data and its sensitivity to some of the new policy initiatives will remain a key focus as we move through the year.
We appreciate your continued trust and partnership. We hope you had a wonderful holiday season and that 2025 is off to a strong start for you.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete, it is not a statement of all available data necessary for making an investment decision, and it does not constitute a recommendation. Any opinions are those of the Wise Investor Group and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Investments mentioned may not be suitable for all investors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance may not be indicative of future results.
