Any Way You Look At It, Lower Returns Are Expected From Equities In 2025

Introduction

Lance Roberts points out in his latest newsletter that “understanding the trajectory of corporate earnings is crucial for investors, as these earnings significantly influence stock valuations and market performance. Economic indicators such as Gross Domestic Product (GDP), the Institute for Supply Management (ISM) Manufacturing Index, and the Chicago Fed National Activity Index (CFNAI) provide valuable insights into the economic environment that shapes company profitability. These indicators can also help investors evaluate whether Wall Street’s earnings estimates are realistic…

During raging bull markets, exuberance about the market can detach from the underlying economic fundamentals and, during these periods, it is not uncommon for Wall Street analysts to continually increase forward estimates on the hopes that the economy will catch up to reality. However, there is a symbiotic relationship between economic indicators and the trajectory of earnings [that we explore below].

1. Gross Domestic Product (GDP)

GDP measures the total value of goods and services produced within a country and, as such, it is a reliable gauge of overall economic health. A growing GDP indicates increased economic activity, typically driving higher corporate earnings due to greater consumer spending and business investment. Conversely, a contracting GDP suggests an economic slowdown, often dampening corporate profits….

There is a high correlation between the market and the corporate profits to GDP ratio…but, as is the case currently, as seen in the graph below, markets can detach from underlying economic realities due to momentum and psychology for brief periods but those deviations are unsustainable in the long term, and corporate profitability, as discussed, is derived from underlying economic activity.

2. The ISM Manufacturing Index

The ISM Manufacturing Index…surveys purchasing managers on critical metrics like new orders, production levels, and employment. A reading above 50 signals expansion, which tends to support earnings growth and a reading below 50 suggests contraction, often foreshadowing economic weakness and declining corporate profits. As of late 2024, the ISM Manufacturing Index has been consistently below 50, marking a manufacturing recession…raising concerns about corporate earnings resilience in 2025.  However, while manufacturing only accounts for about 20% of U.S. GDP, it has a outsized influence that extends across supply chains, amplifying the impact on broader economic activity.

As shown above, corporate earnings growth, which correlates with economic indicators like the ISM Manufacturing index, suggests some caution in the more optimistic Wall Street estimates. However, even if we include the services side of the index, which comprises the bulk of economic growth, and weight it accordingly, we see that the stock market has far outpaced underlying economic activity. Historically, such outsized returns were unsustainable as earnings growth could not meet expectations.

 3. The Chicago Fed National Activity (CFNAI) Index

The CFNAI is a very broad measure of the economy aggregating 85 monthly economic indicators from four categories: production and income; employment, unemployment, and hours worked; personal consumption and housing; and sales, orders, and inventories. A reading above zero indicates above-trend economic growth, while below zero suggests below-trend growth. In October 2024, the CFNAI registered at -0.15, reflecting subdued economic activity. Prolonged readings in negative territory often signal a rising risk of recession. Notably, the employment measure suggests that the annual rate of change in employment will continue to decline, industrial production will slow, and personal consumption will moderate lower.

The CFNAI’s broad scope provides a nuanced view of how various economic forces combine to affect corporate earnings. With production and employment metrics deteriorating, the outlook for robust earnings in 2025 appears increasingly strained. As shown, a high but volatile historical correlation exists between the CFNAI and corporate earnings.

While the above are the major indicators to pay attention to heading into 2025, there are others.

• Consumer Spending: This accounts for nearly 70% of U.S. GDP. Recent data shows retail sales growth has slowed, indicating cautious consumer behavior amid inflationary pressures and higher interest rates. Lower spending reduces revenue prospects for consumer-focused companies.
• Labor Market Trends: While the unemployment rate remains low, job openings and wage growth are moderating. A weakening labor market could hinder disposable income growth, further challenging consumer-driven earnings.
• Corporate Margins: Rising costs for raw materials, labor, and borrowing are compressing profit margins. If these trends persist, corporate earnings in 2025 could be weaker than anticipated.

Wall Street Earnings Estimates for 2025

Currently, Wall Street analysts project record corporate earnings for 2025….However, historical patterns suggest caution: analysts tend to overestimate earnings by roughly 30% (the median) one year in advance. With economic data signaling a slowdown, these estimates may be overly optimistic.

One key risk lies in valuation metrics. The S&P 500 trades at approximately 22.43 times forward earnings, well above the historical average of 15.8 times. If earnings fall short of estimates, stocks could face downward pressure as investors reassess valuations.

Conclusion

Subdued manufacturing activity, slowing GDP growth, and cautious consumer behavior all point to an economic environment less supportive of aggressive earnings growth than what Wall Street is projecting for 2025. As such, investors must carefully navigate the disconnect between high Wall Street expectations and softening economic conditions. Here are some strategies to consider:

• Diversification: Spread investments across sectors to mitigate risks tied to specific industries, particularly those heavily reliant on consumer spending or manufacturing.
• Focus on Quality: Prioritize companies with strong balance sheets, consistent cash flows, and defensible market positions. Quality companies tend to weather economic slowdowns better than their peers.
• Monitor Leading Indicators: To anticipate earnings revisions, pay close attention to ISM Manufacturing, CFNAI, and consumer spending trends.
• Prepare for Volatility: Elevated valuations leave little margin for error. If earnings fall short of expectations, expect heightened market volatility.

If these headwinds persist, corporate earnings may grow much slower or even contract slightly compared to Wall Street’s current projections. For investors, this scenario could mean lower returns from equities, particularly in high-growth sectors more sensitive to earnings disappointments.

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