Morgan Stanley is raising red flags about U.S. equity markets heading into 2025.
Sky-high valuations could set the stage for a turbulent year, according to Mike Wilson, the bank's chief U.S. equity strategist. The S&P 500 is "extremely expensive" and investors should brace for lower multiples and more challenging conditions after 2024's rally, he says on the most recent edition of Morgan Stanley’s “Thoughts on the Market” podcast.
"The majority of this year's [2024] equity returns were multiple expansion. That's not going to happen again in 2025," he says. Morgan Stanley forecasts a 5% contraction in valuation multiples, which will likely cap equity market gains despite improving corporate earnings.
For investors, the implications are clear: The days of easy gains seem a distant memory and the importance of the stock picking will likely emerge.
S&P 500 Outlook For 2025: Modest Returns With Wide Upside And Downside Scenarios
The S&P 500 index — as tracked by the SPDR S&P 500 ETF Trust (NYSE:SPY) — is currently trading at 23 times forward earnings. That’s far above its historical average of 16-17.
The elevated valuation leaves little room for error, as stocks could quickly become vulnerable to negative economic surprises or a deterioration in corporate profitability.
Morgan Stanley's base case for 2025 calls for high single-digit total returns for U.S. equities, driven primarily by modest earnings growth.
But Wilson warned that lofty valuations will act as a drag, making further gains increasingly difficult. "You get what you pay for," he cautions, adding that investors may need to recalibrate their expectations.
“The consensus views are generally fairly narrow around the soft landing and that’s very priced as well. So, the risks are that the consensus view doesn’t play out. And that’s why we have two bull and two bear cases in the U.S.” he added.
Morgan Stanley’s optimistic scenario envisions the S&P 500 climbing to 7,400 points by the end of 2025, while its most pessimistic projection predicts a sharp decline to 4,600 points.
Key Risks That Could Derail The Market In 2025 According To Morgan Stanely
Morgan Stanley's outlook for 2025 is shaped by a host of unsettling risks that threaten to shake markets out of their comfort zone.
- Valuation compression: With the S&P 500 already trading at a premium, any disappointment in earnings or macroeconomic data could trigger a significant pullback.
- Policy uncertainty: Fiscal challenges loom large as Congress debates how to handle the expiration of the Tax Cut and Jobs Act (TCJA) in 2025. In addition, escalating tariffs on China and ongoing geopolitical tensions could reignite inflationary pressures.
- Earnings pressure: While Morgan Stanley expects earnings to grow, the pace of that growth may not be enough to offset shrinking multiples.
- Consensus overconfidence: Investors are overwhelmingly betting on a "soft landing" for the U.S. economy, leaving little room for the market to price in a less favorable outcome.
Market Opportunities For 2025: Stock Picking And Rotation
Wilson stressed that stock-picking will be critical in 2025, highlighting the high level of valuation dispersion across the market.
"Clients are really being rewarded for taking single-stock exposures," he noted, underscoring the opportunities available to investors who are prepared to navigate sector and style rotations.
In this environment, investors will need to move away from relying on broad market momentum and instead focus on selective stock-picking and tactical rotation strategies to manage the growing uncertainty.
As Wilson puts it: "We're going to do what we did this year—rotate around from a style and size perspective, depending on the macro outlook."
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