Thoughts on the Market: Will 2024’s Weak Finish Extend into the New Year?

Podcast Information:

• Title: Thoughts on the Market
• Host/Author: Morgan Stanley
• Description: Short, thoughtful and regular takes on recent events in the markets from a variety of perspectives and voices within Morgan Stanley.
• Episode: Will 2024’s Weak Finish Extend into the New Year?
• Release Date: January 6, 2025

Introduction

In the January 6, 2025 episode of Thoughts on the Market, Morgan Stanley's Chief Investment Officer and Chief U.S. Equity Strategist, Mike Wilson, delves into the disappointing close to the 2024 equity markets and explores the potential implications for 2025. This comprehensive analysis sheds light on the multifaceted reasons behind the market's downturn in December 2024 and outlines the strategic considerations for investors moving forward.

Overview of 2024 Market Performance

Mike Wilson opens the discussion by acknowledging that while 2024 was generally a robust year for U.S. equity markets, December marked a notable downturn. He attributes this weak finish to a confluence of several critical factors:

1. Strong Pre-December Rally:

   • From September to the end of November, equity markets experienced one of their strongest three-month periods, capping impressive one and two-year gains.
   • This rally was driven by:
     • A reversal of recession fears during the summer.
     • An aggressive 50 basis point start to a new Federal Reserve (Fed) rate-cutting cycle.
     • A decisive Republican sweep in the elections, leading to the unwinding of hedges by early December.
   • Wilson notes, “This also lines up with my view in October that The S&P 500 could run to 6,100 on a decisive election outcome” ([00:00]).

2. Rising Long-Term Interest Rates:

   • Since the summer peak of recession fears, long-term interest rates have surged, particularly the 10-year U.S. Treasury yield, which increased by 100 basis points.
   • This rise occurred concurrently with the Fed's 100 basis point rate cuts, suggesting potential skepticism from the bond market regarding the Fed's aggressive monetary easing amid stabilizing employment data.
   • Wilson explains, “The term premium has risen by 77 basis points from the September lows... may be a byproduct of this dynamic and uncertainty around fiscal sustainability” ([00:00]).

3. Strengthening U.S. Dollar:

   • The Trump election victory contributed to a stronger dollar, approaching a 10% year-over-year rate of change, a threshold historically known to pressure S&P 500 earnings growth and guidance.
   • Wilson observes, “The US dollar is quickly approaching the 10% year over year rate of change threshold that has historically pressured S&P 500 earnings growth and guidance” ([00:00]).

Market Breadth Concerns

Wilson highlights a significant warning sign in the form of declining market breadth:

• Divergence Between S&P 500 Index and Market Breadth:

  • There is a rare widening divergence between the S&P 500's ratio to its 200-day moving average and the percentage of stocks trading above their 200-day moving average.
  • This divergence suggests that while the index remains buoyant, fewer individual stocks are sustaining their upward momentum.
  • Wilson states, “This divergence can close in two ways. Either breadth improves or the S&P 500 trades closer to its own 200 day moving average, which is about 10% below current prices” ([00:00]).

• Potential Scenarios:

  • Improved Breadth: Dependent on lower interest rates, a weaker dollar, clearer tariff policies, and stronger earnings revisions.
  • Index Adjustment: The S&P 500 could retrace closer to its 200-day moving average in the absence of the above factors.
  • Wilson predicts, “In the absence of those developments, we think 2025 could be a year of two halves, with the first half being more challenged before the more market friendly policy changes can have their desired effects” ([00:00]).

Liquidity and Global Money Supply

Wilson discusses the persistent gap between index pricing and market breadth, attributing it to:

• Generous Liquidity Provisions:

  • Treasury and Fed policies have injected substantial liquidity into the markets.
  • Central bank interventions globally have also played a role.

• Monitoring Global Money Supply:

  • The year-over-year change in global money supply denominated in U.S. dollars serves as an indicator of key market inflection points.
  • Recent rollovers in this measure signal caution.

• Wilson advises, “The recent moves in rates in US dollar is just another reason to stick with quality equities” ([00:00]).

Investment Strategy for 2025

Given the current market landscape, Wilson outlines a cautious yet strategic approach for investors:

1. Emphasis on Quality Equities:

   • A quality bias is recommended, rooted in the belief that the market is in a later cycle environment where high-quality stocks tend to outperform.
   • Quality stocks exhibit stronger earnings revisions and relative strength.

2. Selective Exposure within Cyclicals:

   • Investors should remain selective within cyclical sectors, focusing on segments demonstrating clear relative strength in earnings revisions.
   • Key sectors identified include:
     • Software
     • Financials
     • Media and Entertainment
   • Wilson emphasizes, “As long as these dynamics persist, we think it also makes sense to stay selective within cyclicals and focus on areas of the market that are showing clear relative strength in earnings revisions” ([00:00]).

Conclusion and Outlook for 2025

Mike Wilson concludes by projecting that 2025 may unfold in two distinct halves:

• First Half: Likely to encounter more challenges due to lingering high interest rates, a strong dollar, and ongoing uncertainties in fiscal policies.
• Second Half: Potential for more favorable market conditions as policy changes take effect, possibly improving market breadth and supporting equity valuations.

Wilson remarks, “It's also been aided by interventions from other central banks... Our quality bias is rooted in the notion that we remain in a later cycle environment” ([00:00]).

He reinforces the importance of maintaining a focus on quality and selectively investing in sectors with strong earnings prospects to navigate the anticipated volatility in the coming year.

Key Takeaways

• Weak Finish Factors: Strong pre-December rally, rising long-term interest rates, and a strengthening U.S. dollar contributed to the weak end of 2024.
• Market Breadth Warning: A widening divergence signals potential challenges ahead unless breadth improves.
• Liquidity Dynamics: Persistent liquidity from central banks underpins the current market structure but indicates caution.
• Investment Strategy: Prioritize quality equities and selective exposure within strong cyclical sectors to mitigate risks in 2025.

Notable Quotes

• “The S&P 500 could run to 6,100 on a decisive election outcome.” – Mike Wilson ([00:00])
• “The term premium has risen by 77 basis points from the September lows... may be a byproduct of this dynamic and uncertainty around fiscal sustainability.” – Mike Wilson ([00:00])
• “The US dollar is quickly approaching the 10% year over year rate of change threshold that has historically pressured S&P 500 earnings growth and guidance.” – Mike Wilson ([00:00])
• “This divergence can close in two ways. Either breadth improves or the S&P 500 trades closer to its own 200 day moving average, which is about 10% below current prices.” – Mike Wilson ([00:00])
• “As long as these dynamics persist, we think it also makes sense to stay selective within cyclicals and focus on areas of the market that are showing clear relative strength in earnings revisions.” – Mike Wilson ([00:00])

Disclaimer

The episode concludes with a standard disclaimer emphasizing that the content provided is informational and should not be construed as financial advice.

This detailed summary encapsulates the critical insights from Morgan Stanley’s Thoughts on the Market podcast, offering valuable perspectives for investors and market enthusiasts navigating the complexities of post-2024 financial landscapes.