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

Summary6 min read

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:

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]).
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]).
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:

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.
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.

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Transcript2 lines

[00:01]
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Welcome to Thoughts on the Market. I'm Mike Wilson, Morgan Stanley CIO and chief U.S. equity strategist. Today on the podcast I'll be discussing the weak finish to 2024 and what it means for 2025. It's Monday, January 6th at 11:30am in New York, so let's get after it. While 2024 was another solid year for US equity markets, December was not. The weak finish to the year is likely attributable to several factors. First, from September to the end of November, equity markets had one of their better three month runs that also capped historically strong one and two year advances. This rally was due to a combination of events including a reversal of recession fears this summer, an aggressive 50 basis point start to a new Fed cutting cycle, and an election that resulted in both the Republican sweep and and an unchallenged outcome that led to covering of hedges into early December. This also lines up with my view in October that The S&P 500 could run to 6,100 on a decisive election outcome. Second, long term interest rates have backed up considerably since the summer when recession fears peaked. Importantly, this 100 basis point backup in the 10 year US treasury yield occurred as the Fed cut interest rates by 100 basis points. In my view, the bond market may be calling into question the Fed's decision to cut rates so aggressively in the context of stabilizing employment data. The fact that the term premium has risen by 77 basis points from the September lows is also significant and may be a byproduct of this dynamic and uncertainty around fiscal sustainability. As we suggested two months ago, if the change in the term premium was to materially exceed 50 basis points, the equity market could start to take notice and hurt valuations. Indeed, equity multiples peaked in early to mid December around the time when the term premium crossed this threshold. Finally, the rise in rates and the Trump election win has ushered in a stronger dollar, which is now reaching a level that could also weigh on equities with significant international exposure. More specifically, 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. All these factors have combined to weigh on market breadth, something that still looks like a warning. The divergence between the S&P 500 index as a ratio of its 200 day moving average and the percent of stocks trading above their 200 day moving average has rarely been wider. This divergence can close in two ways. Either breath improves or the S&P 500 trades closer to its own 200 day moving average, which is about 10% below current prices. The first scenario likely relies on a combination of lower rates, a weaker dollar clarity on tariff policy and stronger earnings revisions. 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. It's also worth pointing out that this gap between index pricing and breadth has been more persistent in recent years, something that we attribute to the generous liquidity provisions provided by treasury and the Fed. It's also been aided by interventions from other central banks. While not a perfect measure, we do find that the year over year change in global money supply in US Dollars is a good way to monitor key inflection points, and that measure has recently rolled over again. The recent moves in rates in US dollar is just another reason to stick with quality equities. Our quality bias is rooted in the notion that we remain in a later cycle environment, which is typical of a backdrop that is consistent with outperformance of this cohort and the fact that the relative earnings revisions for this high quality factor are inflecting higher. 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. These groups include software, financials and media and entertainment. Thanks for listening. If you enjoy the podcast, leave us a review wherever you listen and share thoughts on the market with a friend or colleague today.
[04:17]
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The preceding content is informational only and based on information available when created. It is not an offer or solicitation, nor is it tax or legal advice. It does not consider your financial circumstances and objectives and may not be suitable for.