Predicting the Future: What Will the 2025 Stock Market Outlook Hold?

2024 was a great year in the market, with the S&P 500 setting new all-time highs more than 50 times. This leaves us in a precarious position in 2025, as the market has already priced in all the good news, while ignoring the negatives. The market is…optimistic that only good things will continue. Bloomberg has used the fitting phrase priced to perfection or more accurately priced for perfection.

This leaves the market at risk when the inevitable bad news comes along. The bad news could be resurgent inflation, higher tensions between the US and China, or a trade war sparked by the incoming administration. The outcome is the same; the US stock market will probably see a pullback. The market is extremely expensive by most measures and those multiples are only justified in the best of circumstances. If the situation changes, those multiples become untenable.

Based on this outlook, I’m making some changes to portfolios. Big picture, I’m taking some of last year’s gains off the table and I’m moving the remaining equities to a more conservative allocation.

2025 Economic Predictions:

• Inflation will be higher than expected in 2025, forcing the Fed to keep rates high. I think there’s a better chance that the Fed (on net) raises rates this year.

• Consumer spending will slow, leading to an overall economic slowdown.

• Ukraine and Russia will negotiate an end to their war, leaving hundreds of thousands dead and millions impacted for nothing.

• World attention will shift from Russia to China, as their aggression and economic practices are highlighted by a Trump administration chock full of China-Hawks.

• Tensions between China and the US will continue to increase, with the potential for a trade-war to turn into full-blown economic war.

• Cybersecurity and corporate espionage will dominate headlines as both nation-states, like China and North Korea, and criminal elements utilize AI for cyberattacks.

• AI growth will put added pressure on utilities and infrastructure, increasing demand for fuel like natural gas and commodities like copper.

• The US will recognize the downside to Globalization; we traded our middle-class jobs for cheap TVs and goods from overseas.

• Imported goods become more expensive due to tariffs, allowing American manufacturers to better compete with imported goods that are often priced artificially low. Ultimately, this could lead to investment in American manufacturing and a renaissance in our manufacturing capabilities.
  

2025 Portfolio Changes

My equity portfolio had very few changes in 2024. Going into 2025, I’m updating a few things based on the forecast / predictions I already mentioned. Before I go on, I have to mention that these aren't specific recommendations to buy or sell any specific security.

Funds dropped:

• iShares MSCI Japan

• iShares US Tech Breakthrough

• Select Sector Industrial

• Energy Select Sector

• SPDR Aerospace & Defense

• iShares iBonds 2026 Treasury
  

Funds added:

• US Aerospace & Defense

• GSCI Commodity Indexed Trust

• Cybersecurity & Tech

• US Manufacturing
  

Funds Kept:

• Gold

• US Infrastructure
  

You might notice that a few of the changes are lateral moves, like moving from one Aerospace and Defense fund to another, while others are more material changes, like cutting the Select Sector Industrial fund.

To that end, I want to share my thought process behind each fund that is being added or kept.

iShares US Aerospace & Defense Fund

While it is slightly more expensive than XAR (.4% vs .35% internal expense ratio), ITA provides more concentrated exposure to US companies in the defense space. The top 10 holdings are very concentrated, comprising over 70% of the fund. For hedging against geopolitical uncertainty, I prefer the concentrated approach.

iShares S&P GSCI Commodity Indexed Trust

GSG provides exposure to a range of commodities, including energy, agriculture, livestock, and metals. If inflation is an issue, commodities are historically one of the best hedges against increasing prices.

Likewise, 9.5% of the fund is invested in copper futures. I debated including a copper mining-specific ETF, as the demand for copper is both growing and, in my opinion, currently undervalued by the market. Copper is key to both AI, conducting the vast amount of energy required for powering data centers, and the renewable energy transition. I passed on the mining ETF for a technical reason: the specific fund is too small, and I was worried about both liquidity and bid-ask spreads. Instead of including the copper mining ETF, I felt that the allocation to copper futures in GSG was sufficient.

iShares Cybersecurity & Tech ETF

Instead of investing directly in AI, I prefer looking at the industries powering the AI revolution, like infrastructure and copper mining, and the industries being revolutionized, such as Cybersecurity.

AI has already had significant impacts on cybersecurity, as AI is able to automate tasks like threat detection and log analysis. Going forward, AI will allow companies to react to security incidents more quickly and effectively.

Apart from AI, nation-state cyberespionage is becoming more prevalent…or at least more widely known. Chinese hackers recently breached the US Treasury and US telecoms like Charter and Windstream, plus they stole sensitive military data from the President of the Philippines. These are just the latest in decades of cyberespionage acts by China.

Cybersecurity has long been looked at as an afterthought by many companies, however that view is changing considering the recent hacks and security breaches.

US Manufacturing ETF

US Manufacturing has faced a secular decline since the late 1970s, as much manufacturing has been shipped overseas in exchange for cheaper goods. Goods produced in China were cheaper for several reasons:

· Low labor costs

· Chinese government loans provided cheap financing

· Adoption of the standardized shipping container lowered shipping costs by 50% from the 1960s to 1990s.

· Lax environmental regulations

· Government support for State-Owned Enterprises (SOEs), particularly those they deemed Champions.

While manufacturing has always been a hallmark of the American economy, Covid showed the brittleness underlying the American supply chain. Manufacturing and shipping delays caused Ford pickups to be parked unfished for lack of computer chips, runs on toilet paper and baby formula, and increases in the price of electronics like Raspberry Pi computers.

Seeing this weakness highlighted the issue for many and has led to a renewed interest in American manufacturing. President Trump has proposed several significant tariffs, designed to make American companies more competitive.

Tariffs on imported goods effectively increase the price of those goods. Since the imported goods are typically the lowest priced goods in the market, raising the price of imported goods will increase the market price as well. The thesis is that the higher price will allow American manufacturers to compete on price, while still making a profit.

I’ve mentioned before that I expect this will increase inflation in the short term, but long-term it will spur American manufacturing independence.

iShares Gold ETF

Gold was one of the best performing assets of 2024, partially in reaction to sticky inflation numbers. The market underestimated inflation in 2024 and I believe they will do the same in 2025, putting Gold in a good position to benefit.

iShares US Infrastructure ETF

AI requires a few things: silicon chips, vast amounts of data, and enough power for a small country. The iShares US Infrastructure ETF provides exposure to the last requirement through its holdings in both energy and utilities.

Power must be generated and then transported to data centers providing the backbone for AI adoption; energy companies provide natural gas, oil, and coal, which utilities turn into electricity. That electricity is then transported to its destination by the utilities. As AI continues to grow, so will the demand for electricity and investments in corresponding infrastructure.

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Additional Thoughts

I read a memo from Howard Marks of Oaktree Capital yesterday, after I had already finished writing the rest of this note. He made some insightful points about the current state of the market that I want to share.

I’m borrowing (and editing) liberally from Marks’ memo On Bubble Watch. I highly recommend you read the entire thing, which you can find here. For the abridged version, keep reading.

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On Bubble Watch

I’m often asked whether there’s a bubble surrounding the Standard & Poor’s 500 and the handful of stocks that have been leading it…The seven top stocks in the S&P 500 – the so-called “Magnificent Seven” – are Apple, Microsoft, Alphabet (Google’s parent), Amazon.com, Nvidia, Meta (owner of Facebook, WhatsApp, and Instagram), and Tesla. I’m sure I don’t have to go into detail regarding the performance of these stocks; everyone’s aware of the phenomenon. Suffice it to say that a small number of stocks have dominated the S&P 500 in recent years and have been responsible for a highly disproportionate share of its gains.

But is it a bubble?

For me, a bubble or crash is more a state of mind than a quantitative calculation.

In my view, a bubble not only reflects a rapid rise in stock prices, but it is a temporary mania characterized by – or, perhaps better, resulting from – the following:

• highly irrational exuberance (to borrow a term from former Federal Reserve Chair Alan Greenspan),

• outright adoration of the subject companies or assets, and a belief that they can’t miss,

• massive fear of being left behind if one fails to participate (‘‘FOMO’’), and

• resulting conviction that, for these stocks, “there’s no price too high.”

“No price too high” stands out to me in particular. When you can’t imagine any flaws in the argument and are terrified that your officemate/golf partner/brother-in-law/competitor will own the asset in question and you won’t, it’s hard to conclude there’s a price at which you shouldn’t buy.

“The three stages of the bull market”:

The first stage usually comes on the heels of a market decline or crash that has left most investors licking their wounds and highly dispirited. At this point, only a few unusually insightful people are capable of imagining that there could be improvement ahead.

In the second stage, the economy, companies, and markets are doing well, and most people accept that improvement is actually taking place.

In the third stage, after a period in which the economic news has been great, companies have reported soaring earnings, and stocks have appreciated wildly, everyone concludes that things can only get better forever.

The important inferences aren’t with regard to economic or corporate events. They involve investor psychology. It’s not a matter of what’s happening in the macro world; it’s how people view the developments. When few people think there can be improvement, security prices by definition don’t incorporate much optimism. But when everyone believes things can only get better forever, it can be hard to find anything that’s reasonably priced.

Bubbles are marked by bubble thinking. Perhaps for working purposes we should say that bubbles and crashes are times when extreme events cause people to lose their objectivity and view the world through highly skewed psychology – either too positive or too negative.

I always say the riskiest thing in the world is the belief that there’s no risk. In a similar vein, heated buying spurred by the observation that stocks had never performed poorly for a long period caused stock prices to rise to a point from which they were destined to do just that. In my view, that’s George Soros’s investment “reflexivity” at work. Stocks were tarred in the bursting of the TMT Bubble, and the S&P 500 declined in 2000, 2001, and 2002 for the first three-year decline since 1939, during the Great Depression. As a consequence of this poor performance, investors deserted stocks en masse, causing the S&P 500 to have a cumulative return of zero for the more than eleven years from the bubble peak in mid-2000 until December 2011.

Lately, I’ve been repeating a quote I attribute to Warren Buffett: “When investors forget that corporate profits grow about 7% per year they tend to get into trouble.” What this means is that if corporate profits grow at 7% a year and stocks (which represent a share in corporate profits) appreciate at 20% a year for a while, eventually stocks will be so highly priced relative to their earnings that they’ll be risky. (I recently asked Warren for a source on the quote, and he told me he never said it. But I think it’s great, so I keep using it.)

The point is that when stocks rise too fast – out of proportion to the growth in the underlying companies’ earnings – they’re unlikely to keep on appreciating. Michael Cembalest has another chart that makes this point. It shows that prior to two years ago, there were only four times in the history of the S&P 500 when it returned 20% or more for two years in a row. In three of those four instances (a small sample, mind you), the index declined in the subsequent two-year period. (The exception was 1995-98, when the powerful TMT bubble caused the decline to be delayed until 2000, but then the index lost almost 40% in three years.)

In the last two years, it’s happened for the fifth time. The S&P 500 was up 26% in 2023 and 25% in 2024, for the best two-year stretch since 1997-98. That brings us to 2025. What lies ahead?

The cautionary signs today include these:

• the optimism that has prevailed in the markets since late 2022,

• the above average valuation on the S&P 500, and the fact that its stocks in most industrial groups sell at higher multiples than stocks in those industries in the rest of the world,

• the enthusiasm that is being applied to the new thing of AI, and perhaps the extension of that positive psychology to other high-tech areas,

• the implicit presumption that the top seven companies will continue to be successful, and

• the possibility that some of the appreciation of the S&P has stemmed from automated buying of these stocks by index investors, without regard for their intrinsic value.

Finally, while I’m at it, although it’s not directly related to stocks, I have to mention Bitcoin. Regardless of its merit, the fact that its price rose 465% in the last two years doesn’t suggest an overabundance of caution.