The S&P 500, the benchmark index of US stocks, is poised for a third consecutive year of gains, reflecting robust economic growth and steady corporate earnings. Projections indicate the index will rise to 6,500 by the close of 2025, translating to a 9% price gain and a total return of 10% when dividends are factored in. Earnings growth is expected to remain solid, with forecasts of an 11% increase in 2025 and 7% growth in 2026.
Economic Growth Driving Revenue Growth
Corporate revenue growth often mirrors nominal GDP trends. With real GDP projected to grow by 2.5% in 2025 and inflation cooling to 2.4%, the S&P 500’s sales growth aligns with these economic conditions, forecasted at 5%. This outlook reflects a stable and sustainable expansion, underpinned by macroeconomic stability.
Earnings and Valuation Metrics
Earnings per share (EPS) for the S&P 500 are estimated at £268 for 2025 and £288 for 2026. These figures align with median market forecasts but fall slightly below some more optimistic estimates.
However, valuations remain a concern. The price-to-earnings (P/E) ratio for the index has climbed by 25% over the past two years to 21.7x, placing it in the 93rd historical percentile. This elevated valuation level could amplify the impact of potential market shocks. By comparison, the index traded at a multiple of 17x at the end of 2022.
Key Risks for 2025
High valuations and an optimistic economic backdrop pose risks for investors. Elevated P/E multiples may dampen short-term returns and magnify downturns during negative market events.
Potential risks include:
- Trade Policy Uncertainty: Tariffs on select imports could disrupt earnings, particularly for companies heavily reliant on international revenue streams.
- Bond Yield Volatility: Unexpected increases in bond yields may pressure equity valuations.
- Macroeconomic Shocks: While current policy expectations are steady, any deviation could impact investor sentiment.
Conversely, a more favourable fiscal policy or dovish Federal Reserve actions could boost returns. Strategic investors might consider using periods of low volatility to secure upside potential or hedge risks through financial instruments.
The Magnificent 7: A Shifting Dynamic
The so-called “Magnificent 7” tech giants are expected to continue outperforming the broader index, albeit with a reduced margin of around 7 percentage points in 2025 – the smallest gap in seven years.
These companies have benefitted from superior earnings growth, but the growth differential between them and the rest of the S&P 500 is narrowing. Earnings growth for these tech leaders is forecasted to surpass the broader market by just 6 percentage points in 2025 and 4 points in 2026, down from an estimated 30 points in 2023.
Furthermore, macroeconomic factors like trade policies and economic expansion favour the S&P 493 (the remaining constituents of the index). With a higher proportion of domestic earnings, these companies are less exposed to international trade friction compared to the tech-heavy Magnificent 7, which derive nearly half of their revenues from overseas.
Opportunities in Mid-Cap Stocks
Mid-cap stocks offer compelling opportunities for investors seeking value and growth. The S&P 400, a mid-cap index, has a long history of outperforming both small- and large-cap indices. Mid-caps boast similar consensus earnings growth to their larger counterparts while trading at a lower P/E multiple of 16x. These characteristics make mid-caps an attractive option for diversifying portfolios.
AI Investment: Transitioning to the Next Phase
The investment landscape surrounding artificial intelligence (AI) is evolving rapidly. In 2025, the focus is expected to shift from infrastructure investment to monetising AI applications. This new phase includes companies that leverage AI to drive revenue growth, particularly in the software and services sectors.
Unlike infrastructure-focused firms, these application-driven companies offer longer-term growth potential and are less sensitive to fluctuations in economic growth or interest rates. Investors seeking exposure to AI could benefit from targeting these firms, which are poised for a sustained, secular uptrend.
Strategic Insights for 2025
As the S&P 500 enters another year of growth, a balanced investment approach is crucial. While the outlook remains optimistic, risks associated with high valuations and macroeconomic uncertainties should not be ignored. Diversification across mid-caps, selective exposure to tech leaders, and a strategic focus on AI-driven opportunities could provide robust returns in a dynamic market environment.
