How might US stocks fail in 2025?
Pick your fighter: Contagion from a Bitcoin crash? Disappointing fiscal deficits? Weaker conversion of deficits into corporate earnings? No rebound in the credit impulse?
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.
There was one chart in my November 2024 Market Strategy that I found greatly disturbing.
It was the investor consensus on which asset class is expected to perform best in 2025.
Almost half of respondents believe that US stocks will do best, while bonds and cash are out of favor. It’s not hard to build the scenario they have in mind for this: Strong real growth fueled by Trump’s tax cuts and deregulation.
It’s a scenario that I agree in principle with. It’s a reasonable base case for next year. And it’s in line with my overall macro framework that the US bull market rests on strong pillars, being the domestic energy production boom, a favorable demographic environment, strong household balance sheets and an AI innovation theme to justify it all.
What makes me so uneasy is how disastrous the track record of the answer to this question is. For 2024, investors loved bonds. For 2023, they loved cash. For 2022, they loved emerging markets, the S&P 500 and Bitcoin. For 2021, they loved emerging markets even more. As I covered in more detail in the market strategy article: In ALL of these instances, the consensus long for the coming year performed very poorly.
So, what are potential catalysts that could force an underperformance of stocks vs. cash and bonds next year?
TLDR Summary
In principle, US stock returns can only be poor vs. cash and bonds if a material economic weakening occurs. It feels unlikely because Trump’s election seems to have removed the one big overhang, namely falling fiscal deficits which has been my main concern over the past year. It’s however in the nature of financial markets that unintuitive developments happen more often than the ones that can reasonably be expected. I see four possible downside catalysts which can happen in isolation or in combination.
Firstly, Bitcoin might crash and cause contagion in the economy and the stock market. Leverage in the Bitcoin economy is unknown, but potentially very high. The spot ETF launch has made this trade crowded which is why it likely needs some pain. The bull case is a basket of speculative theses, none of which are proven and some of which are theoretically unsound. Bitcoins correlation with US stocks is high and it is destined to stay high because adoption has grown a lot. If it crashes, the negative wealth effect may take stocks down with it.
Secondly, deficits might come down or expand less than expected. Their recent acceleration has fueled the bull market, but this might be a temporary distortion from a final spending spree of the outgoing administration. Tax receipts may still have cyclical catch up potential with outlays and voters have given the incoming administration a mandate to get deficits under control. Tax cuts might not meet expectations.
Thirdly, even if deficits do meet expectations or surprise to the upside, the efficacy of their transmission mechanism into the real economy might decrease going forward. The saving rate has been quite low recently vs. historical standards. If US households choose to save more (for example because of unemployment fears or because their portfolios fall in value), they may convert the savings injection from the government into corporate earnings at a slower pace.
Fourthly, the valuation of the S&P 500 indicates that markets are also expecting a credit impulse following lower interest rates. Growth in loans and leases has been very weak in the last two years. If this credit impulse doesn’t happen, the stock market might have to rerate lower because earnings may disappoint.
Poll
By the time you have read the article, I’d be curious to hear your opinion on which scenario is most likely:
Bitcoin Contagion
Bitcoin is a basket of speculative theses right now, none of which it has proven historically and some of which are theoretically unsound.
It failed in 2022 as a store of value against inflation.
It failed to provide shelter from economic stress through diversification from productive assets in 2020 and in 2022. It’s beta was in fact very high during those stock market drawdowns.
It has so far failed to meaningfully reduce its volatility to provide for a larger portfolio allocation with investors. Gold has a valuation anchor in production cost that is largely an exogenous variable. Bitcoin’s production cost is a function of adoption which removes that valuation anchor. In my opinion, this systematically destabilizes price. Investors are volatility averse. The aggregate portfolio share of an asset (class) typically correlates with its volatility. Bitcoin is about fives times as volatile as gold. Yet, Bitcoin ETFs have now grown their assets under management to about half the size of their Gold counterparts. Something will have to give.
Aside from a few small countries and some gambling shitcos, it has also so far not gained traction as a reserve asset. Further adoption is highly unlikely because institutions have little to gain and a lot to lose. Monetary policy can be conducted through liquidity management (fiscal and credit impulse) and more Bitcoin adoption would likely be detrimental to the society. The top 1,000 holders own about 20% of the outstanding float, the top 10,000 investors own 30%. Lifting this asset up to monetary status would be an enormous government directed wealth transfer to a small minority without democratic legitimation. It would undermine social order.
Perhaps I will be proven wrong on some or all of the theses above. But one thing seems clear to me: Whether the long term bull case for Bitcoin has merit or not, the spot ETF launch this year has likely pulled the adoption curve forward a lot.
These spot ETFs have accumulated almost $100bn in net assets after not even one year. And they now have option chains, too, which likely amplifies leverage on top of these net assets.
When a crowd pushes into an asset (class) with that much excitement, I believe it to be highly unlikely that they can earn decent returns in the near term, in absolute terms as well as in risk-adjusted terms.
Given its high correlation with the stock market, especially the US tech sector, I consider this an important warning signal. Therefore, I have been wondering what the pain trade could be for these investors next year. I see two scenarios that would be very different in nature.
Either we will see a significant market correction that will take Bitcoin down with it due to its high correlation with momentum stocks. Or we will see strong earnings growth through productivity gains that will make Bitcoiners chase stocks when they realize that their coins don’t participate in these earnings.
I asked the almighty crowd intelligence to get help with this question. Unfortunately, it doesn’t know either:
Taking the investor consensus on a strong stock market performance for next year into account, I feel like the probability of scenario one is higher. At least it’s likely higher compared to the probability most investors assign to it.
Such a scenario would likely require deleveraging in momentum stocks and Bitcoin. A potential trigger for that could be disappointing corporate earnings. What could be the catalysts for such an earnings disappointment? It must have something to do with overall liquidity. Fiscal impulse or credit impulse liquidity that is.
Fiscal stimulus decline
The S&P 500 has advanced by 70% since its low in October 2022. An important driver for this was an accidental reacceleration of deficit spending. I am calling this accidental because nobody planned for it. Nobody implemented specific stimulus programs to aide the economy. It happened for two related reasons. Firstly, the inflation surge nuked corporate profits because costs outgrew revenues. This caused a shortfall in tax receipts. Secondly, the Fed’s rate hikes increased the Treasury’s funding costs. I have covered this in great detail over the last two years.
Since mid 2023, this fiscal impulse has been declining because tax receipts are catching up with outlays. Corporations get used to higher price levels. They pass them on to consumers and margins are recovering.
So far I have expected this to continue. However, outlays have recently reaccelerated. And while it’s not definitive yet, it’s possible that tax receipts have started plateauing.
This latest deficit spike is likely a driving force for the bull market acceleration we have seen over the past few months. Trump’s election is a fitting catalyst for investors to rationalize it.
The big question is this: Is this deficit increase just the outgoing administration with a final spending spree? Will spending slow down in February, potentially aided by cost cutting efforts of the incoming administration? Or is this an overall trend reversal from the last 15 months? An economic weakening that launches the next fiscal bazooka whether policymakers want it or not? If it’s the former, we may have a catalyst for an underperformance of stocks vs. bonds and cash in 2025.
You might want to counter here: We did have receding fiscal deficits in the early 2010s as well, which was a solid bull market. And we had anemic private sector borrowing during that time as well, another burden for liquidity creation. Loans and leases in bank credit have been growing at just 2% recently. The early 2010s were at a similar level (more on that in the next section).
I have so far taken the same line of reasoning and I believe there are solid reasons for it. After all, the recent fiscal impulse has been so enormous that it will take years for consumers to convert it into consumption, investment and borrowing. Their balance sheets are much stronger than they were a decade ago.
There are however two important differences between the fiscal impulse decline in 2013 and a potential repeat of that in 2025:
Back then, investors were very concerned about a fiscal cliff. This issue was more likely properly priced in than it is today. I wrote about that here.
In 2013 and 2014, the US shale revolution was inflicting its full force on the US economy. The oil price dropped 50% between mid 2014 and early 2015. This was likely a huge boost for consumer spending and corporate earnings.
It’s important to understand that I am not making any predictions here. I am simply entertaining various scenarios.
Inefficacy of fiscal stimulus
The most amazing aspect about the US fiscal impulse is how effectively and immediately it gets transmitted into the economy and the stock market. The bottom of the S&P 500 in October 2022 happened only three months after the July 2022 fiscal deficit bottom.
For this mechanism to work, the private sector must activate the savings injection from the public sector without much delay. One metric that measures this efficacy is the personal saving rate, i.e. how much of disposable income gets stashed away.
If this metric rises, it indicates that consumers are reducing the pace at which they convert the fiscal impulse into corporate earnings. You can see that saving surges often coincided with recessions and/or with periods where stock market returns were subpar.
For example, there was a visible increase in the saving rate in the 1970s compared to the 1960s. In real terms, 1966 to 1981 was one of the worst periods for US stock market investors.
There were also surges in the saving rate in the early 1980s and 1990s (which coincided with recessions) and the late 2000s (which contributed to the Great Recession).
The pandemic stimuli have greatly distorted this metric. However, they appear to be mostly digested by now. And the saving rate seems to be below historical benchmarks. If we see an increase in this saving rate in the near term, it may be a burden to corporate earnings. Fiscal deficits may then not have the same efficacy that we have seen in the last few years.
Unresponsive credit impulse
Part of my base case for the coming years is that normalizing interest rates will be a catalyst for private sector borrowing. As you can see in the chart below, growth of loans and leases in bank credit has been quite weak over the last two years.
As pointed out earlier, US households have very strong balance sheets today which is a stark contrast to the early 2010s when credit growth has been equally slow. This time, the Fed has deliberately stopped credit demand through extremely hawkish policy. Rate cuts should therefore be very effective.
Markets generally agree with this view. The US stock market is trading at a quite elevated P/E ratio right now. It clearly anticipates an acceleration of earnings which will likely require a credit impulse. If that doesn’t happen, stocks may have to rerate lower.
Sincerely,
Your Fallacy Alarm
If interest rates fall further, as we expect them to, so do the government’s interest payments on the $35 trillion debt load. I saw something that said roughly half of every dollar paid in taxes is used to pay interest (about $1 trillion per year in 2024). If Interest rates cut down to 1%, it reduces the net interest payment by 2/3rds, roughly $300-$400bn. I’d say that’s a strong incentive to cut rates. If we keep going, every tax dollar will go to net interest payments, and what will we do? Borrow more and more? No. I mean, yes, we will do that anyway, but they will cut rates faster than anticipated because if they don’t we won’t have fiscal spending at all.
Is it possible credit growth has been higher than bank credit growth implies due to rise of private credit?