A Secular Bull Market Will Face Strong HeadwindsCME: Micro E-Mini S&P 500 Futures ( CME_MINI:MES1! )
The Year of the Dragon is quickly approaching the end. If you invested in U.S. stocks, the chances are you have a pretty good year so far. Let’s review how major U.S. stock market indices performed (data as of December 30th):
• The blue-chip Dow Jones 30 trading at 42,992 Midday today, up 12.8% in 2024. This is a back-to-back gain after a 13.7% annual return in 2023. This year, the Dow performed better than its 5-year average of 8.5%.
• The broad market index S&P 500 quoted at 5,899, up 23.7% this year, ahead of its 5-year average of 14.5% but below the 2023 gain of 24.2%.
• The Tech-heavy Nasdaq Composite closed at 19,453, up 29.6% year-to-date, which is below its 2023 gain of 43.4%, but above its 5-year average of 17.1%.
• The small-cap Russell settled at 2,212, up 9.1% YTD, below last year’s 15.1%, but above the 5-year CAGR of 6.1%.
U.S. stocks grew less spectacularly comparing to 2023, however, they still outperformed its global peers, from developed countries to emerging markets alike:
• The Nikkei 225 (Japan) gained 21.1% in 2024. However, this remarkable performance is dented when considering the 11% Yen depreciation against the dollar this year.
• The SSE (China) gained 14.8%, above its 5-year aggregate of 13.2%. Depending on when you entered the Chinese stock market, your return could vary significantly.
• The FTSE 100 and the Stoxx 50 indices were up 5.4% and 8.6% YTD, respectively. The stock performance in Europe lags the U.S. in 1-year, 3-year and 5-year terms.
• The Nifty (India) gained 9.9% this year and 68.3% total in five years. This showcases India as a growing world economy in the 21st century.
• The Ibovespa (Brazil) lost 9.4% in 2024 and gained only 3.2% over five years.
The 2025 Outlook
The new Trump administration will assume power on January 20th, and the Year of the Serpent will start on January 29th (the Lunar New Year). Judging from campaign promises and new Cabinet nominations, investors expect dramatic policy changes in the coming months and years. Heightened uncertainties will result in higher stock volatility, which increases the overall risk of investing.
With a lot still up in the air, even the Federal Reserve does not factor in policy changes in their economic forecast. Today, I will attempt a discussion on the stock market valuation through the lens of the Discounted Cash Flow (DCF).
In January, during The Leap — Paper Trading Competition by TradingView, I will publish a deep-dive analysis on the “Magnificent Seven” stocks, on how they will fare under the new administration policies, and how they will impact the S&P 500 index together.
To refresh our financial knowledge, the DCF model says that an asset’s value is the present value of its expected future cash flows.
In the numerator, Cash Flow is a function of revenue minus cost. In the denominator, the weighted average cost of capital (WACC) is applied to discount the cash flows.
Potential policy impacts on business growth (corporate revenue and profitability):
• Tailwind: The “America First” policy is bullish on U.S. businesses. It will help bring manufacturing back onshore, create new jobs and support consumer spending.
• Tailwind: Lowering corporate income tax from 21% to 15% will improve profitability.
• Headwind: Higher tariffs will raise retail prices as well as input costs for manufacturing. Higher prices will reduce sales volume for most businesses.
• Headwind: Slashing federal spending will reduce sales revenue from industries relying on government spending, including healthcare, retirement and defense spending.
Potential policy impacts on borrowing costs:
• Headwind: The recent rebound in inflation has caused the Fed to hold back on future rate cuts. Fewer cuts mean higher expected future interest rates. This is the main reason behind the 700-point plunge in the Nasdaq following the December FOMC.
• Headwind: Higher tariffs will fuel inflation. Learning from the past, the magnitude of tariffs could be large, making it impossible to find alternative products without higher costs. This will further reduce the Fed’s appetite to lower interest rates.
Taking as a whole, it is my opinion that U.S. stocks will face more headwinds than tailwinds in 2025. The structural changes in how to run the government more efficiently will be positive over the long run, but they will cause pain if you are caught in the middle. Overall, I would adopt a more defensive strategy when trading U.S. stocks.
Trade Setup with Micro E-Mini S&P 500 Futures
With heightened uncertainties, I would prefer shorter-term trading strategies based on incoming information and avoid making longer-term directional bets.
We could explore setting up a trade one week ahead of a “Big Report Date”, including the monthly CPI and nonfarm payroll reports and the FOMC meetings eight times a year. With higher volatility, investors tend to overreact to these big data. This makes short-term outsized gains more likely when you are proven correct in your view, by tapping into the leveraged investment instruments like futures.
Micro E-mini S&P 500 futures (MES) offer smaller-sized versions of CME Group’s liquid benchmark E-mini S&P 500 futures contracts. They are designed to manage exposure to the 500 U.S. large-cap stocks tracked by the S&P 500 Index, widely regarded as the best single gauge of the U.S. stock market. The Micro E-mini S&P 500 futures contract is $5 x the S&P 500 Index and has a minimum tick of 0.25 index points.
With Monday quote of 5,954, each March contract (MESH5) has a notional value of $29,770. Buying or selling one contract requires an initial margin of $1,522.
Hypothetically, if a trader wants to trade the January 3rd, 2025 Nonfarm Payroll report, he could long or short the MES contract on Monday, December 30th, 2024.
Generally speaking, solid job growth tends to point to the economy overheating. This would raise the Fed’s motivation to keep interest rates high. On the contrary, higher unemployment may prompt the Fed to lower interest rates to help out.
Theoretically, if a trader wants to trade the January 15th, 2025 CPI report, he could long or short the MES contract on or around January 8th, 2025.
Typically, lower inflation supports the Fed to bring rates down to a long-term normal level, while persistent high inflation would force the Fed to keep rates higher for longer.
Referring back to the DCF model, higher interest rates would reduce the present value of asset price, while lower rates would raise the price.
A follow-up on the MES is scheduled to publish on January 20th, 2025, at the start of the LEAP contest. With the “Magnificent Seven” accounting for 30% of S&P 500 valuation, I would apply a collective trend of these stocks to construct a trading strategy.
Happy Trading.
Disclaimers
*Trade ideas cited above are for illustration only, as an integral part of a case study to demonstrate the fundamental concepts in risk management under the market scenarios being discussed. They shall not be construed as investment recommendations or advice. Nor are they used to promote any specific products, or services.
CME Real-time Market Data help identify trading set-ups and express my market views. If you have futures in your trading portfolio, you can check out on CME Group data plans available that suit your trading needs www.tradingview.com
