Analysts often test the relationship between two variables by plotting a sample of observations on a chart and then conducting a linear regression. In this process, one draws a line of best fit somewhere in the scatterplot and calculates the R-squared — the degree to which that line explains the relationship between those two variables.
Simply put, the R-squared tells us if changes in one variable will tell us anything about how another variable will change.
Sometimes, the R-squared is very low — like what you’re about to see below.
This type of statistical analysis is important in markets because what you might intuit about the relationship between two variables doesn’t always come through in practice.
Almost all major Wall Street strategists expect the S&P 500 to generate a high-single digit to low-double digit return in 2025.
If everyone thinks the market will do well, does that mean we’re actually more likely to be disappointed?
Bespoke Investment Group reviewed the past 25 years’ worth of data and found that the magnitude of strategists’ one-year forecasts had little relationship with what the market actually did.
“[T]here is absolutely zero correlation between strategist targets and what the market does in the year ahead,” the analysts wrote on Dec. 24. “The scatter chart below shows the r-squared between the two, which is 0.0. You can’t get less correlated than that! And what happens when strategists are bullish and expecting a double-digit increase like they are for 2025? It’s a coin flip.”
Wall Street strategists’ bullishness won’t help you nail the next year’s return.
Every day, someone is sounding the alarm on how the stock market’s value and performance is due to a handful of massive companies.
Goldman Sachs analysts explain: “The top five stocks in the S&P 500 account for 29% of the index’s market capitalization. This level is the highest since 1980. The stocks are, in order of market capitalization, Apple, Nvidia, Microsoft, Amazon and Alphabet. As can be seen in Exhibit 58, the level of concentration has no bearing on returns over the next 12 months. The R-squared, which explains the variance in equity returns attributed to the level of concentration, is negligible, at 0.04%. The results are the same if one uses alternative measures of concentration, such as the top 10 stocks.”
High market concentration is notable, but it’s not a bearish trading signal.
When the dollar appreciates against other currencies, the value of sales generated abroad become less valuable in the U.S. This is why dollar strength is considered a headwind for multinational American companies that do a lot of business outside of the country.
But the earnings of the S&P 500, which generates about 41% of sales abroad, are driven by more than just currency fluctuations.
FILE – The likeness of George Washington is seen on a U.S. one dollar bill, Monday, March 13, 2023, in Marple Township, Pa. (AP Photo/Matt Slocum, File) ·ASSOCIATED PRESS
That’s why when Morgan Stanley’s Michael Wilson ran the numbers for the S&P, it wasn’t obvious that dollar strength would be a major drag to earnings.
“[I]ndex-level EPS growth exhibits a weak statistical relationship relative to the dollar’s rate of change,” Wilson observed.
Currency fluctuations can affect earnings, but it’s rarely the dominant driver of the stock market’s aggregate earnings.
One of the hottest debates among market participants today is about the timing of rate cuts from the Federal Reserve.
All other things being equal, a rate cut is generally considered a dovish development.
However, Fed policy decisions occur in the context of a very complex economy, which usually has a greater impact on stock prices. This means prices can move regardless of rate cuts, rate hikes, or no move on rates.
Last September, BofA’s Savita Subramanian examined the relationship between stock price performance and an initial Fed rate cut. From her research note: “[W]e found that S&P 500 returns in the months leading up to the first rate cut did not have a consistent relationship with 12m fwd returns (Exhibit 15-Exhibit 16). Similarly, how close the S&P was to its 52-week high was also not predictive (Exhibit 17). When the Fed first cut rates in 1995 (a soſt-landing), TTM S&P returns were +26%, the S&P was within 1% of its all-time high, and the index still returned 23% in the NTM.”
Recent market performance and initial rate cuts alone won’t tell us where the market is headed.
According to Ritholtz Wealth Management’s Callie Cox, a pattern emerges depending on whether the economy goes into recession in the 12 months following an initial rate cut. Again, it’s a reminder that there are often bigger forces at play than the Fed alone.
The price-to-earnings (P/E) ratio may help us understand if a security is expensive or cheap relative to history.
But it won’t tell us where prices are headed over the next year.
“[T]he correlation between the S&P 500’s forward P/E and subsequent one-year performance — going back to the 1950s — is -0.11, which means there is virtually no relationship,” Schwab’s Liz Ann Sonders and Kevin Gordon observed.
Historical data suggests P/E ratios may tell us something about long-term returns. But they appear to tell us almost nothing about near-term returns.
While it may be the case the stock market usually goes up, how much it goes up in a given year can be unpredictable.
Also, “usually” does not mean “always,” which is to say the market also goes down sometimes. And it is effectively impossible to accurately predict when those down years will happen.
Unfortunately, past returns aren’t particularly helpful in predicting future returns either.
“Returns are all over the map,” Ritholtz Wealth Management’s Ben Carlson wrote.
Sometimes the stock market goes up a little. Sometimes a lot. Sometimes it goes down. Rarely will you get an average return.
The point of this discussion is to remind you to never count on the signal of a single metric when trying to understand the direction of another metric. That’s rule No. 1 of analyzing the economy using data.
The economy and the markets are complex, and the only way to understand them is to consider more than a few metrics as you piece together the mosaic of crosscurrents that define them.
If you take a closer look at all these charts, you’ll notice they all slant bullishly. Historically, earnings have been more likely to grow than contract. And stock market price performance has been far more likely to be positive than negative.
There were several notable data points and macroeconomic developments since our last review:
Shopping rises to new record level. Retail sales increased 0.4% in December to a record $729.2 billion.
Growth was led by sporting goods, furniture, gas stations, grocery, cars and parts, and electronics.
Card spending data is holding up. From JPMorgan: “As of 09 Jan 2025, our Chase Consumer Card spending data (unadjusted) was 2.1% above the same day last year. Based on the Chase Consumer Card data through 09 Jan 2025, our estimate of the US Census January control measure of retail sales m/m is 0.64%.”
From BofA: “Total card spending per HH was down 0.8% y/y in the week ending Jan 11, according to BAC aggregated credit & debit card data. The South and Midwest saw large y/y declines in total card spending in the week ending Jan 11, likely due to the snowstorms. The LA wildfire impact seems to be more localized since total card spending growth in CA has only slowed modestly so far.”
Unemployment claims tick up. Initial claims for unemployment benefits rose to 217,000 during the week ending January 11, up from 203,000 the week prior. This metric continues to be at levels historically associated with economic growth.
Inflation remains cool. The Consumer Price Index (CPI) in December was up 2.9% from a year ago, up from the 2.7% rate in November. Adjusted for food and energy prices, core CPI was up 3.2%, down from the prior month’s 3.3% level.
On a month-over-month basis, CPI was up 0.4% and core CPI was up 0.3%.
If you annualize the six-month trend in the monthly figures — a reflection of the short-term trend in prices — core CPI climbed 3.2%.
Inflation expectations remain cool. From the New York Fed’s December Survey of Consumer Expectations: “Median inflation expectations were unchanged at 3.0% at the one-year horizon, increased to 3.0% from 2.6% at the three-year horizon, and declined to 2.7% from 2.9% at the five-year horizon.”
Gas prices rise. From AAA: “Oil costs hovering around $80 a barrel have helped push the national average for a gallon of gas four cents higher since last week to $3.10. …According to new data from the Energy Information Administration (EIA), gasoline demand fell from 8.48 million b/d last week to 8.32. Meanwhile, total domestic gasoline stocks rose from 237.7 million barrels to 243.6, while gasoline production popped last week, averaging 9.3 million barrels daily.”
Small business optimism jumps. The NFIB’s Small Business Optimism Index surged in December. From the report’s commentary: “Optimism on Main Street continues to grow with the improved economic outlook following the election. Small business owners feel more certain and hopeful about the economic agenda of the new administration. Expectations for economic growth, lower inflation, and positive business conditions have increased in anticipation of pro-business policies and legislation in the new year.”
Notably, the more sentiment-oriented “soft” components of the index continue to converge with the more tangible “hard” components.
Mortgage rates tick higher. According to Freddie Mac, the average 30-year fixed-rate mortgage rose to 7.04%, up from 6.93% last week. From Freddie Mac: “Mortgage rates ticked up for the fifth consecutive week and crossed seven percent for the first time since May of 2024. The underlying strength of the economy is contributing to this increase in rates.”
There are 147 million housing units in the U.S., of which 86.6 million are owner-occupied and 34 million (or 40%) of which are mortgage-free. Of those carrying mortgage debt, almost all have fixed-rate mortgages, and most of those mortgages have rates that were locked in before rates surged from 2021 lows. All of this is to say: Most homeowners are not particularly sensitive to movements in home prices or mortgage rates.
Homebuilder sentiment improved. From the NAHB’s Carl Harris: “Builders are facing continued challenges for housing demand in the near-term, with mortgage rates up from near 6.1% in late September to above 6.9% today. Land is expensive and financing for private builders remains costly. However, there is hope that policymakers are taking the impact of regulatory hurdles seriously and will make improvements in 2025.”
New home construction starts rise. Housing starts jumped 15.8% in December to an annualized rate of 1.49 million units, according to the Census Bureau. Building permits fell 0.7% to an annualized rate of 1.48 million units.
Offices remain relatively empty. From Kastle Systems: “Peak day office occupancy was 56.5% on Tuesday, up more than 37 points from the previous week as workers returned to work after the holidays. Chicago and New York rose more than 50 points on Tuesday to 67.9% and 65.4%, respectively, and most cities experienced double-digit occupancy increases nearly every day compared to the prior week. The average low was on Friday at 26.3%, up over 10 points from last week.”
Industrial activity ticks higher. Industrial production activity in December rose 0.9% from the prior month. Manufacturing output rose 0.6%. From the Federal Reserve: “In December, gains in the output of aircraft and parts contributed 0.2 percentage point to total IP growth following the resolution of a work stoppage at a major aircraft manufacturer.”
Near-term GDP growth estimates remain positive. The Atlanta Fed’s GDPNow model sees real GDP growth climbing at a 3.0% rate in Q4.
The long-term outlook for the stock market remains favorable, bolstered by expectations for years of earnings growth. And earnings are the most important driver of stock prices.
Demand for goods and services is positive, and the economy continues to grow. At the same time, economic growth has normalized from much hotter levels earlier in the cycle. The economy is less “coiled” these days as major tailwinds like excess job openings have faded.
To be clear: The economy remains very healthy, supported by strong consumer and business balance sheets. Job creation remains positive. And the Federal Reserve — having resolved the inflation crisis — has shifted its focus toward supporting the labor market.
We are in an odd period given that the hard economic data has decoupled from the soft sentiment-oriented data. Consumer and business sentiment has been relatively poor, even as tangible consumer and business activity continue to grow and trend at record levels. From an investor’s perspective, what matters is that the hard economic data continues to hold up.
Analysts expect the U.S. stock market could outperform the U.S. economy, thanks largely due to positive operating leverage. Since the pandemic, companies have adjusted their cost structures aggressively. This has come with strategic layoffs and investment in new equipment, including hardware powered by AI. These moves are resulting in positive operating leverage, which means a modest amount of sales growth — in the cooling economy — is translating to robust earnings growth.
Of course, this does not mean we should get complacent. There will always be risks to worry about — such as U.S. political uncertainty, geopolitical turmoil, energy price volatility, cyber attacks, etc. There are also the dreaded unknowns. Any of these risks can flare up and spark short-term volatility in the markets.
There’s also the harsh reality that economic recessions and bear markets are developments that all long-term investors should expect to experience as they build wealth in the markets. Always keep your stock market seat belts fastened.
For now, there’s no reason to believe there’ll be a challenge that the economy and the markets won’t be able to overcome over time. The long game remains undefeated, and it’s a streak long-term investors can expect to continue.
