How much higher can the US stock market go in 2025?

Barely a day goes past that we don’t hear about how the bull market in US stocks can’t possibly continue. Gross historical overvaluations, extreme concentration of gains among the biggest capitalisation stocks (the so-called Magnificent 7 of Alphabet (Google), Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla), and an increasingly opaque global growth environment.

But here we are, about to close out 2024 at-or-near record highs after logging a second year of +20% returns. Can the US bull market extend its run to three years? This topic was tackled in a recent research report by major broker Citi.

The summary is this: Yes, there’s more upside for US stocks, if only more modestly than previous years, and there are significant risks investors will have to navigate. Let’s investigate the key takeaways from Citi’s report.

How we got here

Citi notes that the market’s remarkable performance so far has been fuelled by the following factors:

• Soft landing scenario / no landing scenario – the belief that the spike in interest rates to combat post-pandemic inflation will not trigger a recession in the US economy (so far the data suggests this to be the case)
• The accelerating influence of Artificial Intelligence (AI) – markets have run on assumed on productivity gains and the subsequent impact on corporate earnings
• Trump Bump – Growth policies associated with a prospective Trump administration

Target setting

Citi’s baseline forecast calls for the S&P 500 to reach 6500 by year-end 2025. The benchmark index for US stocks closed at 6051 on Thursday, which implies Citi is forecasting approximately 7.4% capital upside, plus any dividends that S&P 500 companies might pay.

Cit’s 6500 target sits within a range defined by a bullish scenario of 6900 and a bearish scenario of 5100. Yes, I know what you’re thinking, the bull case looks very close to the target and the bear case is a long way down!

Citi notes the asymmetry in these targets reflects the market’s current valuation starting point. U.S. equities are already priced at historically high levels, the broker suggests, so it considers the downside risk in a bearish outcome to be substantially greater than the potential reward in a bullish scenario.

On that last point, Citi points out that volatility in 2024 was unusually low, without even one 10% decline from peak. The broker tips more frequent and “volatility episodes” next year.

Fundamentals vs valuation

Citi projects around 13% earnings growth for the S&P 500 in 2025, a figure slightly below the consensus forecast of 14%. While that growth number is solid, it starts from a “high valuation point vs history”.

The big question is whether those high valuations can be maintained. On this point, Citi suggests its proprietary fair value model “supports the contention that higher valuations versus history are supportable”.

Supporting factors include:

• The U.S. economy currently defies classical late-cycle/early-cycle patterns, and therefore Citi is in the “no cycle” view camp
• The Federal Reserve’s easing backdrop
• Generally supportive macroeconomic tailwinds
• Thematic tailwinds, “specifically Artificial Intelligence”, the broker notes
• But, Citi also notes that markets have already priced in some of these forward-looking check boxes, and therefore the bar for delivering future earnings gains is now higher.

Magnificent 7

One can prognosticate US stock returns without considering the likely impact of the Mag-7! Citi notes the strong valuation metrics for the S&P 500 are not solely driven by the Mag-7. Instead, the remaining 493 constituents of the S&P 500 are also trading at notably high forward price-to-earnings multiples relative to their own 20-year histories.

Citi forecasts that 2025 should see a greater number of non-Mag-7 stocks deliver improved returns. This broadening of participation is supportive of index growth, and is important as earnings among the Mag-7 decelerates from the current high base. “All told, ongoing broadening is increasingly necessary to drive further equity upside, especially in what could be a more volatile bull market in 2025”, the broker notes.

Risks

Citi’s fair value estimates rely on a few key macro assumptions. These include:

• A modest inflation trend within the 2-3% range
• A slight decline in 2-year Treasury yields as the Federal Reserve begins to cut rates and stable or moderate 10-year Treasury yields
• A broadly steady U.S. dollar
• Incremental improvement in growth expectations, combined with stable long-run GDP trends

Material changes to any of these assumptions would likely force changes to earnings, valuations, and S&P 500 targets. There is little margin for error if earnings or economic data fall short, Citi suggests. The broker pegs the “ugly” scenario as one that delivers a more pronounced correction as unexpected events – be they geopolitical or policy shift-driven – undermine their base case assumptions.

So called policy shifts could emerge as a significant influence on equity markets in 2025. At this stage, Citi notes there is insufficient clarity to fully integrate Trump-related policy changes into their fundamental market framework with confidence.

History suggests that tariffs can act as a headwind to earnings. However, the picture is not entirely negative, as deregulation or targeted tax reforms could provide offsets, even if initial tariff negotiations cause short-term disruption.

For now, Citi concludes that whilst net result of potential policy shifts, once clarified, may prove less dramatic than some fear, the lingering uncertainty could introduce additional bouts of volatility into the market.

Conclusion

Citi’s outlook presents a cautiously optimistic scenario for U.S. equities heading into 2025. The market is transitioning into its third consecutive year of gains, buoyed by its belief in well-known long-term growth drivers.

Yet this optimism is tempered by lofty valuations and a policy environment that remains fluid. 2025 is likely to deliver more volatility as the market reconciles these lofty expectations against the reality of potential policy shifts, macro trends, and corporate earnings results.

Mega-cap names have provided a stable foundation over the past two years, but future gains may depend on a broadening of market participation.

All told, Citi’s view remains positive towards US stocks, but it acknowledges the path forward is now more complex – and could prove to be more eventful – than before.

This article first appeared on Market Index on Friday 13 December 2024.