Back to 5,000?
Nine Reasons why 2025 may end up as a very weak stock market year.
Disclaimer: The information contained in this article is not and should not be construed as investment advice. This is my investing journey and I simply share what I do and why I do that for educational and entertainment purposes.
This article is entirely free to read.
Before I am getting into this, I do want to preempt two points. Firstly, I am still bullish on the US stock market based on the fundamentals I have laid out in great detail over the years. For example, in February 2023 I published a bull case for the S&P 500 to reach 5,000 by Christmas that year, which was a time where most people were only looking at downside. It finished the year at 4,800. Close enough to call that a win. Many bullish macro articles followed and I stand by the points I made in them.
Secondly, calling a top is always much more challenging than calling a bottom on an asset that appreciates at a rate of 10% annually. Every top will eventually recaptured proving the top caller wrong. And an incorrect bottom call will eventually be healed proving the bottom caller right.
I am not just saying this to defend myself against potential ridicule of standing in the way of the greatest bull run of all time (which is however admittedly part of it). I am also saying this to highlight that the below should be taken with a lot of caution. Understand that I am not necessarily trading the points made in this article. I am not providing any financial advice here, but if in doubt the default position is to be long for most people.
Will we really go back to 5,000? No idea to be frank. It’s just a title to make you click. I do however believe that many indicators point to pain next year.
TLDR Summary
Sentiment and positioning data are at very stretched levels for both institutional and retail investors. Some of these metrics have historically proven great predictive power for near-term market performance.
A short squeeze in ‘community assets’ has been an important bull market driver this year. These assets had been pushed far beyond fair valuation levels in 2020/21 which set up great short opportunities. These short trades got crowded and pain has been inflicted on them this year. Once this short squeeze ends, the pain trade will likely change direction.
Of all ‘community assets’, Bitcoin is the largest one with the highest potential of causing contagion once the current bubble pops. It’s correlation with (momentum) stocks is very high.
The ‘bond pain trade’ has been an important bull market driver over the last two years. Investors were concerned due to ultrahawkish Fed policy, high government debt and valuation excesses in 2020/21. The ‘recession and rate cut trade’ was en vogue which caused an imbalance in positioning with too much bond exposure, in both institutional and retail portfolios. Making the bond crowd chase stocks in an environment with economic resilience and the potential for reaccelerating earnings became the release valve to heal this positioning. Initial post-election positioning data indicate that this pain trade may be in its last innings. Purely fundamentally speaking, bonds have a lot of catch up potential with stocks.
The incoming US administration seems very serious about transforming the US tax system towards more tariffs and less income taxes. This will most likely strengthen the Dollar as it will improve the country’s trade balance and it will weaken the currencies of countries depending on exporting to the US. This Dollar strength will likely hurt corporate earnings.
The fiscal drain from income tax payments in April of each year has become an important stock market driver. This is particularly true after years with strong stock market performance. So far, 2024 is shaping up to become the best year for the S&P 500 this century.
The US stock market has reached very high valuation levels that could easily justify a 20% correction without making it look cheap. It’s curious that near-term earnings expectations such as 2025 have been deteriorating while years further out such as 2026 have been improving. 2024 is not even over and the market is already looking past the 2025 earnings season. A valuation-led short thesis is destined to fail. But it should be concerning that there is not valuation floor should some underpriced risks materialize.
1 Institutional sentiment maxed out
I have spoken recently about the sentiment swing we have seen after the presidential election. There is a strong consensus that stocks (and US stocks in particular) will outperform next year at the expense of cash and bonds for the most part. I don’t know for sure, but I expect this to show up in positioning data with the next survey in December.
This sentiment is echoed in various sell side and asset manager market strategy pieces that I have recently read and listened to. I have listed them below with links if you are interested in taking a look yourself.
This consensus makes me very nervous.
2 Retail sentiment maxed out
Similar sentiment is also visible in retail investors. The consumer confidence survey just printed an all time high on the question whether stock prices will be higher in 12 months.
And why should anyone expect lower share prices anyway? Can you think of a catalyst to send us back down? It’s hard for me, too. Sometimes the most powerful bear case is when there’s none.
Such a survey result alone is not a tradable signal. It has in fact been quite noisy over the last decades. But it adds a fragment to the mosaic. The last prominent peak was in late 2017. In 2018, the S&P 500 was down 6%.
3 Squeeze of the ‘community short trade’ about to end
What do assets like TSLA 0.00%↑ , Bitcoin, MSTR 0.00%↑, LMND 0.00%↑ and PLTR 0.00%↑ have in common?
They have performed remarkably well in 2024 and they have a huge retail investor following. This retail investor following used to be a key pillar to short theses on them that made investors a lot of money in 2022. Unsophisticated and valuation-insensitive retail investors had driven their prices far above fair levels in 2020/21. When this deflated, they underperformed.
It seems like this made the short trade on them crowded so it had to feel pain this year. Tesla’s stellar performance this year can hardly be ascribed to improving fundamentals.
I have talked at length about MicroStrategy and Lemonade before. And Palantir is now trading at an incredible 350x core earnings and 50x revenues.
This short squeeze will have to end soon. And once it does, it removes buying pressure on assets that have been the leaders of this bull market.
4 BTC contagion
Of all assets mentioned above, Bitcoin is the most likely candidate for potential contagion. Including all other shitcoins, the global crypto market cap has risen to $3.2tn, about three times larger than Tesla. $1tn to $2tn of that may get wiped out next year when the current fever trade ends. A good amount of that is likely explicitly or implicitly leveraged. It will remove buying pressure or add outright selling pressure on other risk assets, particularly technology stocks, which have proven a strong correlation with Bitcoin in recent years.
I have made various arguments against Bitcoin this year, most notably the excesses we are clearly seeing in the MicroStrategy microcosm and the fact that Bitcoin spot ETFs have swollen to half of the size of their gold counterparts while exhibiting five times the volatility.
There is an additional argument pointing to exuberance I want to include today: Derivatives positioning.
The chart below plots the price of Bitcoin vs. the net short position of a group the CFTC calls 'leveraged funds' in their weekly reporting. Their short interest has risen to about 4x the level it was at the last two peaks.
Why does this matter? It matters because leveraged funds usually don't make directional speculative bets. They employ leverage to exploit market inefficiencies. They engage in cash-futures basis trades for example. When traders with an interest to make a directional bet cause a long overhang in demand for futures and options, they will short the derivative and long the underlying to earn a spread over time.
I had used this as an argument last year to call the long bonds trade crowded when other people concluded the opposite based on positioning data. And what happened? Bonds massively underperformed.
Again, this is not a tradable signal in isolation. 4x can become 8x which can become 16x. This asset has so far not shown any limitations in how far it can go. It's unshortable. But it is another piece to the puzzle that indicates the exuberance in this market segment. How can this not feel pain soon?
5 ‘Bond pain trade’ about to end
I usually haven’t been kind when I covered bonds in the last couple of years. I viewed it as an overcrowded market segment with a bull case predicated on an erroneous macro assessment. Here is a selection of some articles touching on the topic:
These articles aged supremely well. GOVT 0.00%↑ , a large US Treasury ETF has gone nowhere over the last two years. TLT 0.00%↑ , it’s long duration counterpart, is even down 10%. At the same time the S&P 500 is up 50%.
When the last willing investor has finally converted his bonds into stocks, this pain trade has to end. Trump’s election seems to be a suitable catalyst to force that to happen.
Once this pain trade ends, fundamental considerations will matter again. Bonds and stocks will have to find price combinations that fairly represent their risks vs. one another.
The chart below plots the total returns of the S&P 500 and a hypothetical generic 10-Year Treasury bond that I derived from yield data.
I have pointed out before that long term treasury bonds usually compound at a rate equal to nominal GDP growth which is equivalent to liquidity growth. Gold does as well by the way. And stocks in principle, too. But they will retain and distribute earnings which makes their total return exceed GDP/liquidity growth.
This outperformance has another name in finance: It’s called equity risk premium. It’s what investors earn for assuming operating risks in productive assets. This equity risk premium is however not stable. It can be anything between 1% to 5% depending on the method and time frame used to derive it. In the chart above I have added how the S&P/10Y ratio would have moved with a hypothetical ERP of 3% and 4% for illustrative purposes. No matter how you slice it, stocks look very elevated vs. bonds.
6 Dollar strength
The incoming Trump administration appears to be serious about transforming the taxation system from income taxes towards a larger emphasis on tariffs. This would likely strengthen the Dollar because it would improve the country’s trade balance. Imported goods would get more expensive vs. domestic goods and some of the consumption would shift to the latter. It would also weaken foreign economies that depend on US exports which would depreciate those currencies against the Dollar.
7 Unpopular policies from the incoming administration
So far, markets are only looking at the positives from the incoming Trump administration. More real growth, deregulation, renewed fiscal impulse from tax cuts, less geopolitical risks. It’s like a big relief rally from years of paralysis in the White House.
But the new administration also comes with risks. They will restructure the tax system which may cause friction in international trade. Perhaps outright trade wars that could be detrimental to everyone involved. They will deport illegal immigrants which may reduce domestic consumption and labor supply. They will cut government expenses which might be a burden to the fiscal impulse.
To the extent their policies have unpopular consequences, they will make them very early to have more time between these consequences and the next election. Trump won’t need to worry about reelection. But he has a legacy to protect.
Ronald Reagan entered the White House on January 20, 1981 when the S&P closed at 132 points. People put a lot of hope into him and he lived up to a great deal of it. In my opinion, barely any president before or after him that had such a lasting and positive impact on the US and globally. He made the entire political spectrum shift to the right which shaped the regencies of Clinton, Blair and Schroeder.
On January 20, a year after the inauguration of this great president, the S&P 500 stood at 117, 11% lower. Just saying.
8 April 2025 tax drain
Over the last years, the US stock market has become highly dependent on the domestic fiscal spending cycle. This is most visible in how it reacts to the annual fiscal drain in April when tax payments are due. During that month, the US government extracts several hundred billion dollars from the domestic private sector.
This tax drain depends on the stock market performance of the prior year. The more capital gains there are, the more people will owe in taxes a year later. The regression below plots only the last few data points. As you can see, 90% of the April performance of each year can statistically be explained by the fiscal impulse in that month.
2024 is not over yet. But it is currently shaping up to become the best stock market year in this century. The tax drain in April will likely be huge. And it may serve as a suitable catalyst for a correction.
9 Valuation
The two charts below plot the performance of the S&P 500 and its equal-weighted version against 2025 and 2026 earnings estimates.
In my opinion, there are two observations to make here:
Valuation levels have become quite stretched. Based on 2025 earnings estimates, the S&P 500 is now trading at 22x, easily 30% above historical benchmarks. The equal-weighted S&P 500 trades at 18x, not cheap either.
S&P 500 earnings expectations for 2025 have been trending down for the last couple of months. And these estimates are way below 2022 levels. For the equal-weighted S&P 500, both 2025 and 2026 estimates have been trending down. Analysts are not expecting much in terms of earnings momentum in the near-term. Markets are nevertheless marching on, presumably looking past near-term challenges. The promises from Trump’s tax cuts and deregulation are lifting the terminal value. I believe it to be highly unlikely that this ‘longtermism’ won’t get challenged at some point next year.
Sincerely,
Your Fallacy Alarm