2025 and beyond. Can the boom continue?

Roger Montgomery | Montgomery Investments

Many analysts and commentators, applying a plethora of measures, including inflows into ETFs, Berkshire’s cash balance, S&P500 price-to-book (PB) and price-to-earnings (PE) ratios, speculative call-put option volumes and even a ‘Euphoriameter’, warn complacency is everywhere, equities are overvalued, and the market is due for a correction. 

Some of those analysts are the same who feared a recession in 2022, 2023 and 2024; a recession that never transpired. 

That aside, most of us simply want to know; Is it safe to invest? Yes, always. Could the market correct? Yes, it often does.   Should I have a little cash aside as an option over lower prices if the market does correct? Yes, why not?

To gain comfort we often want to hear from experience about whether now is a ‘relatively’ good time to invest or not? Is the market expensive right now?  Can it become even more expensive in 2025?  And what could trigger a crash in 2026 or 2027?

It’s our industry’s duty to proffer fear and uncertainty lest you invest without our help. By predicting a crash or a recession, we sound intelligent and abounding in foresight.  You’re more likely to seek our help if the future looks multifarious and impossible to navigate alone. And so, we paint that picture.  In any case, what witch doctor ever gained fame and notoriety by prescribing two aspirin? 

The background

To begin, I’ll briefly present the bullish arguments we posited for investing in equities in late 2022, 2023 and 2024.  I do this not to boast of success but merely to explain the logic because that logic may also be relevant to 2025.

In 1978, the Hong Kong-based macroeconomic research house Gavekal Research presented a valuable matrix, shown in Figure 1.  I have found it helpful and have frequently referred to it in my 33-year market career. I recommend you study it carefully. 

Figure 1.  Gavekal Matrix

Source: Gavekal Research, 1978

The horizontal (X) axis denotes economic growth, with positive growth to the right of the vertical (Y) axis. The Y-axis denotes inflation, with everything above the X-axis describing accelerating inflation and everything below describing slowing inflation, also known as ‘disinflation’.

For nearly five decades since 1978, and almost without exception, innovative companies with pricing power have done well whenever positive economic growth coincided with disinflation.  And that’s precisely where the lower right quadrant of Gavekal’s 1978 matrix said one should always invest.

As Figure 2., reveals, by late 2022, throughout 2023 and during 2024, despite frequent forecasts of recession by economists and commentators, economies grew (albeit anemically) and disinflation persisted.

Figure 2. quarterly economic growth and disinflation

Source: Tradingeconomics.com

And so, in 2023 and 2024, our thinking was that if Gavekal’s matrix proved right again, disinflation and positive economic growth would produce good returns for investors in innovative companies with pricing power. 

Most of the companies in the Magnificent Seven can be described as innovative companies in which inheres pricing power. Unsurprisingly, the ‘magnificent’ seven became magnificent as investors chased innovative companies with pricing power.

Since the prediction that innovative companies would rise, if not boom in 2023 and 2024, Meta’s share price has increased 414 per cent, Apple 91 per cent, Google 110 per cent, Microsoft 85 per cent and Nvidia 824 per cent.  To be clear, I didn’t predict these shares would boom but mention them to point out the efficacy (again) of Gavekal’s 1978 work – something we did point investors towards in 2022, 2023 and 2024.

Another reason to invest

The reason markets trend is that information is not distributed evenly, and it isn’t adopted simultaneously by all investors.  Some investors jump on a theme early, but doubt, inertia and scepticism also exist, delaying the adoption of a theme or acceptance of a shift in outlook, and their impact causes markets to rise over a period of time rather than instantly.  That reality is perhaps best explained by the aphorism: what the wise do at the beginning, the foolish do at the end. 

Few were convinced the end of 2022 was the right time to dive in. Many believed a recession would reveal any market recovery to be a ‘dead cat bounce’.

So, after the crash of 2022 and compelled to convince investors it’s time to invest, I provided another persuasive argument, this time using basic arithmetic.  I’ll come to that in a moment. 

In September, we showed that the PE ratio for U.S. small caps had been near the lowest this century.  Figure 3., reveals the PE ratio for the S&P600 small cap index had then hitherto been lower only once since 1999, and that was during the GFC. 

Figure 3.  Contemporaneous small cap S&P600 PE ratio; September 2022

Source: Yerdeni.com

In February 2023, I wrote that I was optimistic about 2023 and beyond partly because price-to-earnings (PE) ratios, especially for smaller company shares, were at historical lows. 

Now, a little arithmetic.  If you buy a share of a company today on a PE ratio of, say, 12 times earnings, and you sell those shares in two, three, five or twenty years’ time, on the same PE ratio of 12 times earnings, your return will equal the growth rate of the company’s earnings per share (EPS).

Therefore, if you buy shares in a company whose EPS grows at 15 per cent per year at 12 times earnings and subsequently sell it at 12 times earnings, your internal rate of return (IRR) will equal 15 per cent.

And that learning was important in 2022 when PE ratios were at historic lows because PE ratios measure popularity, and popularity was very low. Therefore, if popularity remained low and you purchased shares in a fast-growing company, you would still make an attractive double-digit return.

At the end of 2022, low PE ratios reflected deep uncertainty and the fact that equity investing was unpopular.  Figure 2., however, revealed PE ratios, and by implication, popularity, is cyclical.  A lack of popularity would inevitably be followed by popularity again.  PE ratios would inevitably expand so investors would not only make a return equivalent to the earnings growth of the underlying company but also benefit from an expansion of PE ratios.

Since September 2022, the S&P500 has risen 70 per cent and the S&P600 small cap index has risen 42 per cent.

What about 2025?

Even if we ignore the above, there are signs of what former US Federal Reserve Chairman Alan Greenspan referred to as irrational exuberance.  It is the case that speculative excesses, often a hallmark of late-stage booms, are increasingly visible. Highly leveraged ETFs pulling in tens of billions of dollars, the MicroStrategy purchase of billions of dollar’s worth of Bitcoin, the rapid rise of meme-coins and the astonishing US$6.3 million sale of a banana taped to a wall all point to heightened animal spirits.

However, the exuberance is in peripheral assets, not in assets core to the financial system's stability through systemically important institutions. 

Sure, a growing body of indicators is now pointing towards a more cautious approach, but in each case, we can reveal reasonably large holes in the argument that they are portents of a crash.

For example, as Figure 4., shows, the PB ratio for the S&P500 is at all-time highs. 

The S&P500 is made up of the most successful 500 companies in the US market.  The best enter the index and the worst leave the index.  Today, the best companies rely far less on physical assets than back when railroads, property and manufacturing were the greatest sources of wealth generation.  Today, its companies with patents, intellectual property and network effects that are the winners. Fewer tangible assets often produce higher returns on lower equity or book value levels.  When the denominator (book value) is lower relative to earnings, the price-to-book ratio will inevitably be higher. 

Prices will inescapably correct at some point, but suggesting this ratio’s current level indicates extreme overvaluation and the risk of an imminent correction is a long bow to draw.

Figure 4. Monthly S&P500 Price-to-Book ratio; to Dec 2024

Source: Factset, Axios

As Figure 5., reveals, the Robert Shiller CAPE ratio is also very high. 

Figure 5. CAPE ratio to December 2024

Source: Multpl

The CAPE Shiller Ratio is a widely followed valuation metric. It currently suggests the S&P 500 is expensive by historical standards. But this metric compares current prices to a 10-year average of inflation-adjusted earnings—a period that includes the pandemic-induced earnings slump. Adjusting for this anomaly paints a less alarming picture. Moreover, the U.S. economy remains robust, with strong corporate profit margins and resilient growth.

All of the above fear-mongering is designed to gain attention, and most forecasts will be inaccurate, leading many of their advocates to scratch their heads and eventually double down on their predictions of a crash; ‘well if it was overvalued when I last warned you, it is even more overvalued now!’  And as the market ascends the wall of worry that will be what you hear more of.  Even a stopped clock is correct twice a day.  The only way to forecast accurately is to forecast often!

As long as the outlook (‘outlook’ is the crucial word here because the market casts its shadow before it) is a combination of disinflation and positive economic growth, there is nothing in the above conga line of indicators and signs that should be relied upon to predict a crash.  As long as those preconditions are met, 2025 should also be a positive year for equities.  Sure, there will be bumps now and then – and if China decides to commence a conflict over Taiwan, all bets are off – but I believe, on balance, 2025 should be another good year for equity investors, especially smaller-capitalised innovative companies with pricing power.

Beyond 2025?

Having suggested 2025 could be another good year for equities, the current rally could pause or retreat on the back of a shift in sentiment in late 2025 or in 2026.  Massive demands on liquidity from the refinancing of a meaningful portion of the world’s US$315t (about US$70 trillion) of global debt borrowed when interest rates were zero could leave less liquidity to sustain the rally in equities, Bitcoin and everything else.  Even if this expected refinancing event did not strain liquidity, fears that it might, could be enough to reverse prices that might indeed be stretched by then.

All prices and analysis at 12 December 2024.  This information has been prepared by Montgomery Investment Management Pty Ltd ABN 73 139 161 701 AFSL 354 564. The content is distributed by WealthHub Securities Limited (WSL) (ABN 83 089 718 249)(AFSL No. 230704). WSL is a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited (ABN 12 004 044 937)(AFSL No. 230686) (NAB). NAB doesn’t guarantee its subsidiaries’ obligations or performance, or the products or services its subsidiaries offer.  This material is intended to provide general advice only. It has been prepared without having regard to or taking into account any particular investor’s objectives, financial situation and/or needs. All investors should therefore consider the appropriateness of the advice, in light of their own objectives, financial situation and/or needs, before acting on the advice.  Past performance is not a reliable indicator of future performance.  Any comments, suggestions or views presented do not reflect the views of WSL and/or NAB.  Subject to any terms implied by law and which cannot be excluded, neither WSL nor NAB shall be liable for any errors, omissions, defects or misrepresentations in the information or general advice including any third party sourced data (including by reasons of negligence, negligent misstatement or otherwise) or for any loss or damage (whether direct or indirect) suffered by persons who use or rely on the general advice or information. If any law prohibits the exclusion of such liability, WSL and NAB limit its liability to the re-supply of the information, provided that such limitation is permitted by law and is fair and reasonable. For more information, please click here.