Anyone who has ever owned stocks knows that many factors influence how they perform. The good news is stock prices have historically risen over time, reflecting participation in the ongoing growth of the economy. This phenomenon ties into the first key pillar of Leelyn Smith’s investment approach: “Economic progress is the engine that builds long-term wealth.”
With the S&P 500 Index approaching its second straight year of 20%-plus performance—marking just the ninth instance of such back-to-back returns since 1950—it’s helpful to understand the conditions when stocks tend to thrive. Recognizing these drivers of stock price appreciation can provide valuable perspective whether markets are soaring or turbulent.
Morningstar identifies four key conditions that tend to drive stock performance[1]: strong economic growth, rising corporate profits, declining interest rates, and low inflation. Let’s break down each one and see how they align with today’s market.[2]
1. Strong economic growth
The growth of the U.S. economy is often measured by Gross Domestic Product (GDP). While it is often assumed that consumer spending accounts for roughly 70% of economic growth, Leelyn Smith Chief Investment Officer Brian Dorn pegs the consumer contribution at closer to 40%–50%, with the rest driven by productivity growth—a measure of worker efficiency.
Despite widespread Wall Street forecasts in 2022 of an “inevitable recession,” GDP growth has expanded for two and a half years. Consumers spent pandemic-era savings while the labor market and wages remained strong. After a period of decline, productivity began picking up again in late 2023, further supporting growth. This condition appears likely to remain positive in the near term.
2. Rising corporate profits
Healthy consumer spending and economic expansion have directly supported strong corporate earnings. Stock prices reflect expectations of future profits.
When companies are profitable, they can:
- Invest in growth through R&D, acquisitions, and hiring
- Reward shareholders through dividends or stock buybacks, increasing earnings per share (EPS)
Growing earnings make stocks more attractive, signaling stability and potential for future growth. After an “earnings recession” in late 2022, S&P 500 companies have since delivered five consecutive quarters of EPS growth, according to FactSet.[3] Wall Street analysts now forecast earnings to rise over 10% in 2025, making this a continuing tailwind for stocks.
3. Declining interest rates
Falling interest rates can benefit stocks in multiple ways:
- Higher Valuations: Lower rates reduce the discount applied to future cash flows, increasing the present value of earnings and driving up stock prices
- Lower Borrowing Costs: Businesses can borrow and invest more affordably, boosting profitability and growth, while consumers benefit from reduced mortgage and credit costs
- Relative Attractiveness: As bond yields decline, stocks become more appealing, often prompting investors to shift capital from bonds to equities
Following a period of near-zero interest rates post-2009, the Fed raised rates aggressively starting in 2022 to combat inflation. However, it pivoted in September 2024, initiating rate cuts totaling a full percentage point. Whether this trend continues or stalls depends on inflation risks, putting this condition on watch.
4. Low inflation
Inflation, which tracks price changes for goods and services, is a key driver of Fed policy. For over a decade post-2009, inflation remained near the Fed’s target of 2%, supporting stock prices. However, inflation spiked to generational highs in mid-2022, peaking at 9.1%.
Rapid rate hikes successfully cooled inflation, but recent trends are less encouraging. Consumer Price Index (CPI) declines have stalled, with slight increases in recent months, partly tied to rate cuts. Proposed policies under the incoming Trump administration could also reignite inflation, making this the most tenuous of the current conditions.
A Goldilocks environment— for now.
For the first time since before the COVID-19 pandemic, investors are experiencing a Goldilocks scenario: all four of the leading conditions conducive to rising stock prices are in place. However, the outlook for inflation and interest rates remains uncertain, introducing some risks that should be monitored carefully.
As you plan for the year ahead, we encourage you to meet with your Leelyn Smith advisor to discuss how the prevailing market conditions may impact your portfolio and long-term investment strategy.
[1] Morningstar, September 3, 2004, “How to Use Large-Cap Stocks in a Portfolio.”
[2] As of December 15, 2024
[3] FactSet, “S&P 500 will likely report earnings growth above 7% for Q3,” October 11, 2024.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Investing involves risk including loss of principal. No strategy assures success or protects against loss.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.