Economic growth and corporate earnings are the key in determining how far a bull market can run.
In brief
- Economic growth and corporate earnings drive market performances. Consecutive years of index highs are possible as long as fundamentals are robust.
- Stock selection is key in times of heightened valuations, both in expensive sectors as well as undervalued parts of the market. Short-term market corrections are normal and investors should not try to time their allocation.
- Investors should evaluate the need to rebalance portfolios, take advantage of dollar-cost averaging to move out of cash and lean into active management.
Having posted two consecutive years of 25%+ return in 2023 and 2024, many investors are anxious that U.S. equities could face an imminent correction. Predicting the precise timing of these corrections is impossible, there are some key observations that could help investors to make rational decisions on U.S. equities.
Index highs do not provide reliable signals
First, the absolute level of stock indices does not tell us much about future performance. The S&P 500 index hit its day close all time high 57 times in 2024, and many investors see this as a reason to hold back on investing or take profit. However, our analysis shows that there is little difference in terms of 1-year, 3-year and 5-year return whether investors invested on the day of stock index all time high, or any other days, as shown in Exhibit 1. While index highs can be useful as a reminder to take a closer look at corporate fundamentals to assess whether the market is running ahead of fundamentals, in itself, this is not particularly useful in helping to make decisions on asset allocation.
Exhibit 1: Average cumulative S&P 500 total returns
Jan. 1, 1988–Dec. 31, 2024
Source: FactSet, J.P. Morgan Asset Management. *"Invest on any day" represents average of forward returns for the entire time period whereas "Invest at a new high" represents average of rolling forward returns calculated from each new S&P 500 high for the subsequent 3-months, 6-months, 1-year, 2-year and 3-year intervals, with data starting 1/1/1988 through 12/31/2024.
Data reflect most recently available as of 12/31/24.
Second, there have been extended periods where U.S. equities can generate return for investors. For example, S&P 500 recorded five consecutive years of 20%+ gains starting in 1994 due to an economic soft landing. It also made 3 consecutive years of positive return between 2019 to 2021, despite the COVID-19 pandemic in 2020.
This all comes back to economic and corporate fundamentals. Market rallies don’t end because they have been running for too long. Economic growth and corporate earnings are the key in determining how far a bull market can run.
Elevated stock valuations need active selection
At 21.6 times on a 12-month forward price-to-earnings basis in end-2024, the S&P500 is expensive relative to other markets, as well as against its own history. Much of this is led by the surge in artificial intelligence related technology stocks, and this is much cited as the concentration concern in U.S. equities. We do recognize this concern. While we are confident about the medium- to long-term development of AI (artificial intelligence) and this technology benefiting a broad range of industries, not every company that has invested in AI will emerge as a winner. This would require more in depth stock selection to differentiate.
Meanwhile, the U.S. economic growth cycle remains in good shape and this could benefit from cyclical sector companies, including industrials, materials, financial and consumption. The accumulated gain in these sectors over the past two years have lagged behind technology and hence we see this could be a good way to diversify allocation towards U.S. equities. This is also reflected in the expectation for acceleration in earnings growth forecast for companies in S&P 500 excluding the top 10 companies, as seen in Exhibit 2.
Exhibit 2: Contribution to earnings growth in S&P 500
Pro-forma earnings per share, year-over-year percentage points
Source: FactSet, J.P. Morgan Asset Management. *The top 10 S&P 500 companies are based on the 10 largest index constituents at the beginning of each month. Forecast assumes that the top 10 largest index constituents at the time of publication by market cap remain the top 10. Data reflect most recently available as of 12/31/24.
Market corrections are normal
A stopped clock tells the time right twice a day, but it doesn’t mean it’s useful. There are often warnings about imminent market correction and investors should look to embrace such phenomenon instead of trying to time their allocation. As seen in Exhibit 3, on average in the past 20 years, S&P 500 saw an intra-year correction of 14.5%. Even in years where the index has generated positive annual return, the intra-year correction still averaged 11.1%.
Exhibit 3: S&P intra-year declines vs. calendar year returns
Source: FactSet, J.P. Morgan Asset Management. Returns are based on price index only and do not include dividends. Intra-year drops refers to the largest market drops from a peak to a trough during the year. For illustrative purposes only. Returns shown are calendar year returns from 1980 to 2024, over which time period the average annual return was 10.6%. Data reflect most recently available as of 12/31/24.
Some market corrections are brought by market positioning adjustments, or triggered by short-term data swings or policy changes. More sustained downturns in equites are usually brought by prospects of earnings recession. As discussed above, active selection could help to diversify away from sectors and companies that could be vulnerable to earnings downgrade.
Investment disciplines can help to weather through market volatility
What should investors do? First, they should be clear about the appropriate asset allocation, such as stock-bond ratio, that is needed to meet their investment objectives. Following the last two years of equities outperforming bonds, investors may find their equity allocation could be above what they need, if their portfolio is not rebalanced. Rebalancing their portfolio to the desirable allocation proportion implies that they would naturally take profit on outperformers. On the other hand, if there is a correction in the market in the future, further rebalancing would allow investors to add back stocks at a more reasonable valuation.
To deploy cash, investors may opt to add their allocation to U.S. equities in several batches. In a market that we expect to see positive return in the medium term, this dollar cost averaging methods can help investors to take advantage of any potential correction and improve the overall cost of investment.
Given the concentrated performance of U.S. equities in the past two years, active selection should be key to tap under appreciated opportunities, as well as mitigate risks. As mentioned above, not all AI developers will be successful and hence it will be key to identify the potential winners. This is not limited to the tech sector, but other industries who could implement AI solutions effectively.