Euphoria is spreading through financial markets. Stock markets worldwide are reaching new highs, inflation is falling, central banks are easing policies, and recession fears are fading. Yet, a cloud of uncertainty lingers. Concerns over the upcoming election and lofty valuations leave investors questioning whether the stock market can continue its upward climb. As always, there are reasons for optimism—and for caution.
On the positive side, the much-anticipated recession has not materialized. The inversion of the yield curve in March 2022 led many strategists to predict a significant economic slowdown based on historical trends. More than two years later, economic growth hovers around 3%, and while it’s expected to slow to about 2% in 2025, output is still positive.
Consumer spending, which makes up roughly 70% of gross domestic product, remains robust. While large discretionary purchases have slowed, overall spending continues to grow. Recent retail sales, excluding autos and gasoline, increased 0.7% last month and were up 3.7% year-over-year.
The strength in economic data extends beyond retail sales. The Citi Economic Surprise Index, which tracks whether economic data exceeds or falls short of analysts’ estimates, has steadily risen over the past two months, reflecting better-than-expected releases in spending, output, and employment data.
Employment is a key driver of consumer spending, and the labor market is remarkably strong. Federal Reserve Chair Jerome Powell describes the labor market as “weakening, but not weak,” noting that the working-age participation rate is near historic highs, real wages are rising steadily, and unemployment remains low at 4.1%. Powell’s commitment to supporting a strong labor market led to a 0.50% cut in the federal funds rate on September 18 and signaled further eases are likely. The shift away from tight monetary policy has helped bring down long-term interest rates as well.
For example, 30-year mortgage rates are falling, allowing more households to refinance existing debt at lower rates. A refinancing wave would free up cash flow and could support consumer spending moving forward. Lower mortgage costs may also spark increased housing turnover, boosting housing-related discretionary spending, which has been subdued over the past two years under the tight rates regime. These positive trends in interest rates and inflation will also provide relief to small businesses and offer a significant tailwind for global equities.
Corporate earnings are another bright spot. Earnings growth in 2024 is expected to be roughly 11%, surprising many investors. Analysts forecast that this momentum will continue. Nelson Yu, Head of Equities at Alliance Bernstein, sees consensus S&P 500 profit growth at 15% for 2025, with 10% growth outside the U.S. Yu believes earnings growth will persist in the Healthcare, Materials, Industrials, and Technology sectors. Although interest rates may remain elevated compared to the past decade, Yu expects companies to continue generating profits in this environment. “To identify outperformers, focus on companies achieving returns significantly above their cost of capital,” Yu advised in an interview.
Several other positive drivers for stock prices heading into the fourth quarter and 2025 include record stock buybacks, improving market breadth, and the ongoing boom in artificial intelligence. AI’s ripple effects are driving innovation, sparking a wave of new startups, and fueling massive capital investments in data centers and the modernization of the electric grid.
Momentum remains an influential factor. There’s little doubt that the S&P 500 is in a bull market. The index has risen 23% so far this year and 64% over the last two years. Additionally, 76% of S&P 500 stocks are trading above their 50-day moving average compared to less than 40% in April, indicating a broad move higher. Small-cap stocks are also participating in the rally and are currently making new 52-week highs. The Russell 2000 index has jumped 17% over the last six months. Indeed, market technicals look quite attractive.
Of course, the stock market has to clear some high hurdles to extend gains. Valuation is a valid concern. U.S. stocks are expensive by most historical measures, including price-to-earnings, price-to-cash flow, and price-to-book ratios. The forward P/E for the S&P 500 is 24.7, near a 20-year high. The average multiple over that period is just 17.2.
Given elevated valuation levels, there is warranted skepticism about additional multiple expansion. Current valuations already incorporate the move lower in bond yields. The bad news is that rates have already started to rise again after their sharp drop preceding the first Fed rate cut. After hitting a low of 3.62% in mid-September, 10-year bond yields have climbed back above 4%, driven by strong economic data. Higher rates could pressure equity valuations and provide attractive lower-risk alternatives for investors.
Another challenge is whether corporate earnings will meet analysts’ mid-teens growth expectations. While AI-driven productivity gains are expected to bolster earnings in 2025, profit margins are already near multi-year highs. If return on investment for AI spending fails to materialize, companies may struggle to achieve 10-15% earnings growth in a 2% GDP environment. Given the top-heavy nature of the market-cap indices, the giant companies that are leading the AI boom could weigh heavily on the market in a reversal of sentiment.
Global growth poses another risk. While the U.S. monetary easing cycle is focused on policy normalization, easing in other parts of the world is more about addressing economic weakness. Growth in Europe is lackluster. Germany, the region’s largest economy, is suffering from a manufacturing slowdown and France, with the second biggest economy, is grappling with rising bond yields and fiscal austerity. China, once the primary engine for global growth, is also faltering. Despite recent stimulus measures, China’s economy faces deflationary pressures stemming from the collapse of a debt-fueled real estate bubble. A global slowdown could ultimately weigh on U.S. corporate earnings, especially in sectors like information technology, where 59% of revenues come from foreign markets.
Reflecting the more negative outlook, markets outside the U.S. are trading at considerably cheaper valuations. The MSCI All World Ex-U.S. index forward P/E multiple is 14.8, close to its 20-year average of 14.6. The difference between the valuation of the S&P 500 and the rest of the world is an extreme level. U.S. earnings multiples are now 70% higher than the rest of the world, the highest premium in two decades.
As we head toward the U.S. election, political uncertainty looms large. The outcome could have a wide-ranging impact, particularly on trade policy and corporate taxes. With 34 Senate seats up for grabs—23 held by Democrats or Independents and 11 by Republicans—control of the Senate is expected to shift. According to Polymarket, the odds of the Senate flipping to Republicans is 81%. If Republicans win the Senate and the White House remains Democratic, gridlock will likely leave major policies unchanged. However, if Trump returns to the presidency, several of his key policies, such as raising tariffs on China and Mexico, could be implemented via executive order, irrespective of congressional control. Even if the election result was known with 100% certainty, it would still be difficult to pick the winners and losers in the market given there is no way to predict what will actually transpire.
The outlook for U.S. stocks is mixed. While solid fundamentals underpin recent gains, further multiple expansion at this point in the cycle would be unusual. Therefore, further gains will require sustained earnings growth, which will be hard to deliver amid a slowing global economy. Although stocks may not be cheap, they are not necessarily in a bubble. There is reason for optimism. History suggests that the best action for investors is to remain invested, diversify across regions and asset classes and between active and passive strategies, and tune out short-term noise.