Did Santa Get Stuck In The Chimney?

Last week, we discussed that the selloff heading into Christmas was the setup for the beginning of the year-end “Santa Claus” rally. On Christmas Eve, Santa arrived, pushing the markets back above the important 50-DMA. However, the market sold off on Friday to successfully retest the 50-DMA. While it may seem that the “Santa Rally” stalled, I suspect that we could see some buying next week as portfolio window dressing concludes and traders position portfolios in the first two days of January.

As shown, momentum and relative strength are weak currently, but if the market can break back above the 20-DMA, this should bring buyers into the market. As we noted previously, the sell signal keeps a lid on price appreciation, and until that reverses, there is limited upside to the markets over this week. There is also the 24% possibility that a rally fails to materialize entirely. We suggest managing portfolio risk until the market ultimately makes a decisive move.

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We continue to monitor yield spreads, which remain near the lowest level since the “Financial Crisis.” When yield spreads were this low previously, this equated to excessive optimism about financial market conditions. This is the same currently, as investors are willing to overpay for the risk they are taking on. Unfortunately, such has not ended well previously, but yield spreads will be the leading indicator for investors to reduce portfolio risk more aggressively.

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For now, optimism remains high. But as we will discuss today, that is also a problem we need to monitor closely.

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Is Optimism Too Optimistic For 2025?

In “2025 Predictions,“ we showed some early indications of Wall Street targets for the S&P 500 index, and, as is always the case, optimism for the coming year is very high. The median estimate is for the market to rise to 6600 next year, which would be a disappointing return of just 8.2% after two years of 20% plus gains. However, the high estimate from Wells Fargo suggests a 14% return, with the low estimate from UBS of just a 5% return. Notably, there is not one estimate available for a negative return.

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Interestingly, optimism for 2025 has taken on an interesting twist. Over the last two years of above-average returns, earnings growth has come from just the top-7 market capitalization companies in the S&P 500 index. However, analysts now expect earnings to shift from the bottom 493 companies in the index.

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The optimism in these assumptions is interesting because the economy has grown strongly over the last two years, yet those 493 companies could not grow earnings. What will change in 2025? Yes, President Trump has promised to extend the Tax Cuts and Jobs Act, but that doesn’t change the previous tax rate in the last two years. He has proposed to remove tax on tips and social security, but that impacts only a small percentage of the population.

On the other hand, depending on the scale and areas of impact, deregulation could improve earnings, but much of that will have to be passed through Congress, which could prove difficult. The Federal Reserve hopes to continue to cut interest rates, but sticky inflation could slow that process, particularly if economic growth remains strong into 2025. Even if the economy continues to grow strongly, what will cause the shift in earnings growth from those dominant market players to much smaller companies? Such is particularly the case given the continued reversal of monetary liquidity in the economy, with higher borrowing costs and declining consumer savings rates.

However, while analyst’s optimism about earnings growth in 2025 is high, which would take earnings well above the long-term growth trend, those estimates are already reversing toward reality. In the last six months, estimates have dropped by $3 per share and will likely be closer to $220 per share by next year. As shown, earnings tend not to deviate from the long-term trend for long, and typically, those deviations only occur during recessions and immediate recoveries.

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As discussed recently, if earnings revert toward the long-term trend, which should be expected given that earnings are a function of economic growth, the current valuations become more problematic.

“While the bullish optimism is possible, that outcome faces many challenges in 2025, given the market already trades at fairly lofty valuations. Even in a “soft landing” environment, earnings should weaken, which makes current valuations at 27x earnings more challenging to sustain. Therefore, assuming earnings decline toward their long-term trend, that would suggest current estimates fall to $220/share by the end of 2025. This substantially changes the outlook for stocks, with the most bullish case being 6380, assuming a roughly 4.5% gain versus every other outcome, providing losses ranging from a 2.6% loss to a 20.6% decline.”

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But again, those assumptions are based on a continued moderation in economic growth.

Data Suggests A Continued Moderation In Economic Growth

However, to justify the optimism for increased earnings growth, we must also expect that:

1. Economic growth remains more robust than the average 20-year growth rate.
2. Wage and labor growth must reverse (weaken) to sustain historically elevated profit margins.
3. Both interest rates and inflation need to decline to support consumer spending.
4. Trump’s planned tariffs will increase costs on some products and may not be fully offset by replacement and substitution.
5. Reductions in Government spending, debt issuance, and the deficit subtract from corporate profitability (Kalecki Profit Equation).
6. Slower economic growth in China, Europe, and Japan reduces demand for U.S. exports, slowing economic growth.
7. The Federal Reserve maintaining higher interest rates and continuing to reduce its balance sheet will reduce market liquidity.

You get the idea. While optimism about economic and earnings growth is elevated going into 2025, there are risks to those forecasts. Such is particularly true when examining current economic data’s relative strength and trend. Subdued manufacturing activity, slowing GDP growth, and cautious consumer behavior all point to an economic environment less supportive of aggressive earnings growth. As such, investors must carefully navigate the disconnect between high Wall Street expectations and softening economic conditions.

A better way to visualize this idea is to look at the correlation between the annual change in earnings growth and inflation-adjusted GDP. There are periods when earnings deviate from underlying economic activity. However, those periods are due to pre- or post-recession earnings fluctuations. Currently, economic and earnings growth are very close to the long-term correlation.

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Heading into 2025, real personal consumption expenditures (PCE) remain above real retail sales. While such deviations can occur, they tend not to remain that way long, given that retail sales comprise about 40% of PCE. Such suggests that in 2025, PCE will begin to converge with retail sales, resulting in slower economic growth rates.

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The following graph visualizes the plight of the average American by showing the “gap” between the cost of living and income and savings. To fund the current cost of living, consumers must spend all of their income and savings and then subsidize the remainder with almost $4000 in debt annually. This is why total consumer debt continues to rise, which does sustain economic activity in the near term. However, the longer-term impact is slower economic growth as consumers cannot take on excess debt. Also, if interest rates remain elevated, the impact on economic growth is exacerbated.

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So, if economic growth slows next year, as the Federal Reserve expects, why is Wall Street so optimistic?

Why Is Wall Street Always Optimistic?

When Wall Street wants to make a stock offering for a new company, it has to sell that stock to someone to provide its client, the company, with the funds it needs. The Wall Street firm also makes a very nice commission from the transaction.

Generally, these publicly offered shares are sold to the firm’s biggest clients, such as hedge funds, mutual funds, and other institutional clients. But where do those firms get their money? From you.

Whether it is the money you invested in your mutual funds, 401k plan, pension fund, or insurance annuity, you are at the bottom of the money-grabbing frenzy. It’s much like a pyramid scheme – all the players above you are making their money…from you.

In a study by Lawrence Brown, Andrew Call, Michael Clement, and Nathan Sharp, it is clear that Wall Street analysts are not interested in you. The study surveyed analysts from major Wall Street firms to understand what happened behind closed doors when research reports were being put together. In an interview with the researchers, John Reeves and Llan Moscovitz wrote:

“Countless studies have shown that the forecasts and stock recommendations of sell-side analysts are of questionable value to investors. As it turns out, Wall Street sell-side analysts aren’t primarily interested in making accurate stock picks and earnings forecasts. Despite the attention lavished on their forecasts and recommendations, predictive accuracy just isn’t their main job.”

The chart below is from the survey conducted by the researchers, which shows the main factors that play into analysts’ compensation. What analysts are “paid” to do is quite different from what retail investors “think” they do.

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“Sharp and Call told us that ordinary investors, who may be relying on analysts’ stock recommendations to make decisions, need to know that accuracy in these areas is ‘not a priority.’ One analyst told the researchers:

You Aren’t Important

The question becomes, “If the retail client is not the firm’s focus, then who is?” The survey table below clearly answers that question.

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Not surprisingly, you are at the bottom of the list. The incestuous relationship between companies, institutional clients, and Wall Street is the root cause of the ongoing problems within the financial system. It is a closed loop portrayed as a fair and functional system; however, it has become a “money grab” that has corrupted the system and the regulatory agencies that are supposed to oversee it.

How We Are Trading It

Why am I telling you this? To be a better long-term investor, you must understand the game you are playing and where you get your information.

As I have stated, neither we nor anyone else knows how 2025 will turn out. While I would bet against the bulls, there is always the risk of disappointment.

However, Wall Street is incentivized to keep you invested, as that is how they make money. There is nothing wrong with that as long as you understand the game. What is essential to know is that analysts are often wrong in their assumptions, and they revise those assumptions along the way. Therefore, the advice you acted on previously is no longer valid. Notably, while the analysts’ revised “estimates” will eventually be “correct,” it does little to offset the initial investment risk you took under previously wrong information.

Such is why having a very defined set of trading rules can help offset the risk of wrong information over time. These rules won’t offset all your investment risk, nor will they ensure absolute profitability in all scenarios. However, they provide a framework to mitigate the risk of a catastrophic outcome that permanently impairs your capital.

The Rules

1. Cut losers short and let winners run. (Be a scale-up buyer.)
2. Set goals and be actionable. (Without specific goals, trades become arbitrary.)
3. Emotionally driven decisions void the investment process. (Buy high/sell low)
4. Follow the trend. (80% of portfolio performance is determined by the long-term, monthly trend. While a “rising tide lifts all boats,” the opposite is also true.)
5. Never let a “trading opportunity” turn into a long-term investment. (Refer to rule #1. All initial purchases are “trades” until your investment thesis is proved correct.)
6. An investment discipline does not work if it is not followed.
7. “Losing money” is part of the investment process. (If you are not prepared to take losses when they occur, you should not be investing.)
8. The odds of success improve significantly when the technical price action confirms the fundamental analysis. (This applies to both bull and bear markets)
9. Never, under any circumstances, add to a losing position. (“Only losers add to losers.” – Paul Tudor Jones)
10. Markets are either “bullish” or “bearish.” During a “bull market,” be only long or neutral. During a “bear market,” be only neutral or short. (Bull and Bear markets are determined by their long-term trend.)
11. When markets are trading at, or near, extremes do the opposite of the “herd.”
12. Do more of what works and less of what doesn’t. (Traditional rebalancing takes money from winners and adds it to losers. Rebalance by reducing losers and adding to winners.)
13. “Buy” and “Sell” signals are only useful if implemented. (Managing without a “buy/sell” discipline is designed to fail.)
14. Strive to be a .700 “at bat” player. (No strategy works 100% of the time. Be consistent, control errors, and capitalize on opportunities to win.)
15. Manage risk and volatility. (Control the variables that lead to mistakes to generate returns as a byproduct.)

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