CONTRIBUTORS
Chris Galipeau
Senior Market Strategist
Franklin Templeton Institute
Lukasz Kalwak, CFA
Market Strategist
Franklin Templeton Institute
Summary
We believe the variables are in place for continued improvement in market breadth. History tells us that when there is a global rate-cutting cycle, stable to improving real gross domestic product (GDP), and accelerating earnings power, index concentration will abate as investors discover fundamentally attractive ideas across style and capitalization size. In our analysis, these variables are in place as 2025 begins.
We believe the rotation that began in July of 2024 will likely persist given that the economy remains robust, and the breadth of forward earnings power is improving. The significant relative alpha generation from growth over value should moderate. Similarly, we believe breadth is poised to improve across the cap stack. Small-and mid-cap stocks should continue to participate alongside large-cap stocks.
This environment is bullish for the “average stock.”
Historically, the S&P 500 Equal Weight Index1 has outperformed the capitalization-weighted S&P 500 Index2 with the following conditions in place, which we discuss in this paper:
- Lower interest rates/higher liquidity: The fundamental drivers of the equity market are liquidity and earnings. Liquidity is shaped by monetary and fiscal policies, while earnings are closely linked to economic growth
- GDP recovery/acceleration: Unsurprisingly, lower interest rates often align with improving economic growth, as stimulative monetary policy provides the necessary catalyst to support expansion. This combination of enhanced economic growth and abundant liquidity has historically led to strong equity returns across most sectors and investment styles.
- Accelerating earnings-per-share (EPS) growth: One of the most critical valuation models is the discounted cash flow (DCF) model, which estimates a stock’s intrinsic value based on expected earnings and prevailing future interest rates. Having explored the relationship between rates and the stock market, we look at the second key component of valuation; earnings.
- Index concentration: The final statistically significant factor that has historically coincided with the outperformance of the S&P 500 Equal Weight Index is decreasing market concentration. This makes intuitive sense, as bull markets entering their mature stages often see early winners remaining strong.
Conclusion
While current stock market valuations appear frothy, history has shown that strong market performance alone is not a reason to turn bearish. While it is valid to have concerns about potential headwinds, such as tariffs or geopolitical shocks, how these possibilities may play out remains uncertain. Instead of basing strategy on uncertainty, it is important to focus attention on actual data, which presents a constructive outlook for equities.
The US economy is on solid footing, with healthy GDP growth and supportive liquidity conditions as the Fed continues its accommodative stance by cutting interest rates. Historically, this combination of loose monetary policy and rising economic growth has provided a favorable backdrop for EPS acceleration. Importantly, despite elevated valuations, the expected two-year earnings growth outlook remains strong across most US indexes and sectors, suggesting that earnings improvement could justify current price levels.
Our analysis indicates that we may witness a broadening of earnings growth and performance across styles and sectors. Four factors underpin this view: resilient GDP growth, robust earnings potential, a potential peak in market concentration and declining interest rates. These dynamics provide a strong foundation, we believe, for equities to continue performing well in the coming year.
Even given the risks of headwinds, we recommend that investors remain invested in equities, as we are projecting the S&P 500 to close the year in the 6400-6800 range. While we believe technology stocks are likely to perform well due to strong earnings momentum, we also see opportunities in small-cap and value stocks, which may catch up to the technology sector and potentially lead market performance in 2025. This diversified approach positions portfolios to potentially benefit from both ongoing market strength and the anticipated rotation in market leadership.
Endnotes
- Source: S&P Dow Jones Indices. The S&P 500 Equal Weight Index is a size-neutral version of the S&P 500. It includes the same constituents as the cap-weighted S&P 500, but each company is allocated the same weight at each quarterly rebalance. Past performance is not an indicator or a guarantee of future performance. Indexes are unmanaged and one cannot invest directly in an index. Important data provider notices and terms available at www.franklintempletondatasources.com.
- Standard & Poor’s® 500 Index (S&P 500®) is a market capitalization-weighted index of 500 stocks designed to measure total U.S. equity market performance.
WHAT ARE THE RISKS
All investments involve risks, including possible loss of principal.
Equity securities are subject to price fluctuation and possible loss of principal. Small- and mid-cap stocks involve greater risks and volatility than large-cap stocks. There can be no assurance that multi-factor stock selection process will enhance performance. Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods.
Active management does not ensure gains or protect against market declines.
Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments.
Diversification does not guarantee a profit or protect against a loss.