It is currently prediction season, and Wall Street is trying to forecast the closing level of the S&P 500 index in 2025.

Major companies are adjusting models, revising profit expectations, and working hard to depict the direction of the U.S. economy in order to gain a clearer market picture. Goldman Sachs believes the S&P 500 index will reach 6,500 points, while UBS expects 6,400 points. Morgan Stanley's baseline forecast is 6,500 points, but in a more optimistic scenario, it could even reach 7,400 points.

Comparing the last closing price of the S&P 500 index at 5,969.34 points with the average target of 6551.24 points listed by FactSet, market observers expect a return of 9.75% in 2025 - which could represent a "surefire buy opportunity."

But before investing, let's take a look at the math behind this: price targets are merely the value investors are willing to pay for future earnings. Morgan Stanley and Goldman Sachs believe that the market will pay 21.5 times the overall earnings of all companies in the S&P 500 index over the next 12 months.

Currently, investors are paying 22.1 times - meaning by 2025, investors will view future earnings of the S&P 500 index with nearly the same valuation. These valuations are close to the high end of the range over the past decade, showing strong confidence from investors in the market's growth potential.

However, there is a dilemma: when valuations are high, the usual market consensus is that the future target for the S&P 500 index should be lower. Clearly, that is not the case this time.

Higher valuations expose the market to more risks - such as earnings falling short of expectations or changes in the economic environment - making it more difficult to maintain high return levels continuously.

Strategists are formulating important driving factors for 2025 to support expectations of market returns. FactSet data shows that corporate earnings are expected to grow by 15% in 2025, compared to 9.3% in 2024. For example, Trump's second term could lead to tax cuts for businesses and individuals, potentially stimulating consumer spending and corporate profits. Deregulation in some industries could also provide additional momentum for the market.

However, before readers start to doubt the strategists' predictions, it is worth noting that these targets are not completely absurd.

According to calculations from (Barron's), the average annual total return of the S&P 500 index (including dividends) has been 11.7% since 1928. The data is provided by New York University's Stern School of Business and cited in a report by Nicholas Kolas, co-founder of DataTrek Research, on Friday. Kolas noted that the yield on the S&P 500 index is 1.3%, which means if the index follows historical averages, the price return would be 10.4%, roughly in line with Wall Street strategists' forecasts.

"While this is not particularly creative, we cannot blame them for taking the easiest path," Kolas said. "From a historical perspective, a year-end target of 6,500 to 6,600 points is the easiest to defend."

However, it will be even harder to defend scenarios where the average annual total return is greater than 31.2% or less than -7.9%, if applying the standard deviation of 19.6% to the historical average return of 11.7% for the S&P 500 index.

Kolas finds that when returns are extreme, the market often exhibits certain patterns. When valuations are low and the economy is expanding, the S&P 500 index usually has a very good year; however, when faced with high valuations and an economic recession, the index may experience a bad year.

"Given that the current valuation of the S&P 500 index is very high (38 times based on the Shiller P/E ratio), the most important question for anyone investing in the U.S. stock market is the stability of the U.S. economy in 2025. Simply put, it must be very certain that a recession will not occur next year," Kolas said.

The good news is that many indicators show the strength of the U.S. economy. Job growth is positive, with an average of 194,000 jobs added monthly over the past year; the dollar is expected to reach its strongest level in 2024; GDP growth is projected at 2.6% for the last quarter of this year. Recession forecasts have been pushed back and may even be completely eliminated.

For example, Goldman Sachs' Jan Hatzius sets the probability of a recession occurring within the next 12 months at 15%, which is almost in line with the historical average - meaning the likelihood of a major recession next year is not higher than in other years. Recessions typically occur every six to seven years.

"The current economic conditions do not suggest that we are on the brink of a cliff... The economic landscape entering 2025 looks more like an exceptionally strong year, rather than a weak one. Therefore, we expect the S&P 500 index to rise by about 15% in 2025," Kolas said.

The market is overvalued - but until the economy has enough momentum, valuations will temporarily take a back seat.

Article reposted from: Jin Shi Data