By Michael Allison, CFA
The Chart of the Week shows rolling two year S&P 500 returns compared to rolling two year levels of realized volatility going back to 1930. Think of it as the reward to risk ratio for investing in equities.
The past two years have delivered quite a serene stock market rally. While “low volatility, high return” rallies are not uncommon, they almost always come on the heels of the opposite market environment with poor returns and high volatility. 2025 could be shaping up to be a different story from the one we witnessed over the recent past, and history might not be as kind to investors expecting another stress-free year of gains.
Why 2025 Could Break the Streak
1. Monetary Policy Headwinds: The Federal Reserve’s current stance on interest rates suggests tight monetary conditions could persist longer than anticipated. Higher rates reduce liquidity, weigh on corporate earnings, and increase equity risk premiums. This creates a less favorable environment for sustained low-volatility rallies.
2. Geopolitical Risks: From ongoing U.S.-China tensions to potential flashpoints in Eastern Europe or the Middle East, the global backdrop is rife with uncertainties. Markets, while resilient recently, may not shrug off heightened geopolitical risks in the same way in 2025.
3. Valuations: After such a strong rally, U.S. equities are far from cheap. Elevated valuations leave less margin for error.
4. Economic Slowdown: While the U.S. economy has been resilient, leading indicators suggest potential softness in key areas like housing and manufacturing. An earnings recession or weakening consumer spending could introduce downside risk.
The Bull Case: Could the Rally Keep Rolling?
On the flip side, there’s a scenario where the market defies the skeptics. First, if inflation continues its gradual decline, the Fed could pivot to a more dovish stance, reigniting liquidity flows. Second, advancements in AI and other secular growth themes could keep growth sectors like tech powering ahead. Lastly, continued global diversification of supply chains and corporate cost efficiencies could buoy earnings in surprising ways.
It’s worth noting that historical precedent, while informative, isn’t predictive. Every market cycle is unique, and recent rallies have shown an uncanny ability to shake off headwinds. But low-volatility streaks this long are exceedingly rare, and the balance of risks leans toward higher volatility and choppier returns in 2025.
Sources:
1. Convexitas Chart and Commentary - Convexitas Q4 2024 Update
2. Federal Reserve Policy Updates - Federal Reserve Economic Data
3. Historical S&P 500 Valuations - Yardeni Research
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