With stocks reaching a new high just as the midpoint of the year is reached, it is an opportune time to look at what the second half of the year might hold. Rather than the traditional outlook, this will be an examination of the risks versus rewards, considering what is currently priced in financial markets.
One Chart Tells The Stock Story
The massive US tariffs announced on Liberation Day sent the betting odds of recession soaring to 65%, with stocks dragged lower in expectation of lower earnings. As the tariff threat eased and some progress was made on trade agreements, stocks have recovered sharply. The recent 12-day military conflict between Israel and Iran caused concerns about an economically unfriendly oil shock. Still, the US bombing of Iran’s nuclear facilities has led to a ceasefire, which has cooled fears.
The betting odds of recession also tell much of the story about the US 10-year Treasury note yield. Yields fell as fears of an economic downturn rose and have since recovered from the lows, as economic risk appears to have waned. There is more to the story here, as signs suggest that bond markets worldwide are less willing to fund the unfavorable fiscal situations of most countries.
Recent Market Performance
Stocks soared last week on the ceasefire in the Israel-Iran war and the agreement around a framework for US-China trade. The S&P 500 surpassed its mid-February high by 0.5% after having declined by almost 20%. The Magnificent 7, comprising Microsoft (MSFT), Meta Platforms (META), Amazon.com (AMZN), Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOGL), and Tesla (TSLA), has recovered to only 4% below its mid-December level after being as much as 30% under the peak.
Apart from the good news on trade and Iran, the strength in US bank stocks was notable. Last week, the annual Federal Reserve (Fed) stress tests for large banks were better than expected. Additionally, the Fed made some changes to the methodology, which are expected to result in fewer Stress Capital Buffers (SCBs) being required for banks in the future. All other things being equal, less need for capital buffers means better profitability.
Economic Risk
The more economically sensitive cyclical stocks have outperformed less economically impacted defensives since stocks bottomed, marking the peak of recession fears. The current situation is back to pricing in a benign, if not downright optimistic, economic backdrop.
US Stock Valuations
Based on the current 24.3 times current earnings and 23.4 times multiple of 2025 estimated earnings, also known as the forward price-to-earnings ratio, stocks do not look cheap relative to the past. However, historically, the price-to-earnings (P/E) ratio has been correlated with return-on-equity (ROE), which measures how efficiently companies generate profits from the capital provided by their shareholders. Although the ROE is down from its recent highs, it remains above average, which argues for an above-average P/E ratio, assuming this elevated ROE is sustainable. Consensus estimates project a return on equity of 18.6% in 2025 and 19.4% in 2026, up from 17.6% in 2024. To provide perspective, the S&P 500’s ROE was 15.1% in 2019 before the pandemic.
The composition of the large-cap US stock market is crucial to this improved outlook for ROE since much of the boost has come from technology and artificial intelligence-related companies. Even a simple analysis of the S&P 500 shows that at least 43% of the market capitalization is related to these two areas.
As noted earlier, the exceptional return on equity supports the rich stock valuations, and profit margins are elevated relative to historical levels. Profit margins measure the percentage of top-line sales that are converted into bottom-line profits. As a business owner, higher profit margins, all other things being equal, are more valuable. Notably, the profit margins for the technology sector are almost twice the market. In addition, according to FactSet, technology sector earnings are expected to grow at 18% in 2025, while the S&P 500’s earnings are forecast to rise by about 9.1% year-over-year.
Free Cash Flow Matters
According to Warren Buffett, “The value of a business is the cash it’s going to produce in the future, discounted back to the present.” Free cash flow measures the cash left over after a company supports its operations and maintains or invests further in its business. Thus, free cash flow provides a good measure of the money accruing to shareholders as owners.
The free cash flow yield is calculated by dividing the free cash flow by the stock price. Consistent with the price-to-earnings ratio, the cash flow yield suggests that the stock market is not currently cheap, although it has been more expensive at times in the past. This metric assumes that free cash flow remains static, so it can also be interpreted as indicating that investors have more confidence that free cash flow will continue to grow. Indeed, investors should be willing to pay more for a company in which one can have high confidence that the corporate profits accruing to owners will continue to grow.
As a subset of the S&P 500, technology stocks are priced at an even lower free cash flow yield. This valuation premium reflects the optimism about the future of many of these companies and the superior fundamentals of the group as a whole. The profit margins and earnings growth rate for the technology sector have been exceptional, which helps explain the premium valuation assigned by the lower free cash flow yield.
One additional wrinkle is the massive capital spending (capex) that Alphabet (GOOGL), Amazon (AMZN), Meta (META), and Microsoft (MSFT) are investing in artificial intelligence infrastructure. This spending is also depressing the current free cash flow yield for the technology-related stocks on the margin. Massive capital expenditure (capex) spending is often viewed as a red flag for investors, who are typically concerned that the substantial investment will not yield a sufficient return for the companies. However, these four companies are currently being given the benefit of the doubt.
What To Watch This Week
The main of the holiday-shortened trading week will be the monthly jobs report on Thursday. Economists expect June’s gain in nonfarm payrolls to slow to 113,000 from 139,000 in May. Notably, the unemployment rate is expected to rise to 4.3% from 4.2%.
Given the upward trend in weekly continuing claims for unemployment benefits, the expected uptick in unemployment is a reasonable assumption. The upward trend indicates that the job market has been softening as it is taking longer for those losing their jobs to get a new one. With expectations for the US economy rebounding and the risk of recession decreasing, the resilience of the labor market should be closely monitored.
Federal Reserve
Markets currently expect at least two 25-basis-point (0.25%) Fed cuts in 2025, consistent with the median Fed projection. There is a slight chance of a cut in July, but the first move lower in 2025 is fully priced for September.
Conclusions
In the wake of the rebound from the tariff-induced bear market decline in stocks, investors should revisit their risk tolerance, as the robust stock rally over the last couple of years has likely increased their allocation to risk assets. Rebalancing stock and bond allocations toward the target risk level is wise for many investors, especially given the ongoing presence of tariff, geopolitical, and fiscal risks. The key to successful long-term stock investing is staying invested during the inevitable tough times, as rebounds from those bear markets are typically massive and unpredictable in timing, as illustrated by the first half of this year.
Stocks are priced for a benign economic outcome and some support from the Federal Reserve in lowering interest rates. Improving corporate profitability, with 9% earnings growth in 2025 and 14% in 2026, is forecasted to normalize currently elevated valuations. This outcome is certainly possible, if not the most probable, but investors should be mindful that the hurdles at these valuation levels are higher. The artificial intelligence wave is a real phenomenon as adoption continues, so the optimistic scenario is not entirely out of the realm of possibility. This optimism should be tempered by the fact that the economy and earnings can always disappoint, especially if the trade war heats up again; therefore, investors should be prepared for possible turbulence.
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