Why the stock market poses a big risk for 2025 | CNN Business

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Millions of Americans have watched their net worth spike since the pandemic, powered by meteoric gains in the stock market.

Wall Street’s blockbuster returns — the strongest back-to-back years since the boomy Clinton years of the late 1990s — have boosted confidence and encouraged consumers to keep spending at will.

Now, there are growing worries in some corners that things may be getting out of hand, that the price tag on some stocks has become untethered from reality. The fear is that this could set the stage for a market drop so painful that it endangers the overall economy.

“I’m very concerned because the stock market is pricing in nothing but blue skies and sunshine forever,” Mark Zandi, chief economist at Moody’s Analytics, told CNN in a phone interview. “The market is very richly valued, bordering on frothy,” he said, referring to unsustainably high valuations.

The Nasdaq, powered by the artificial intelligence boom and the Magnificent Seven group of tech stocks, surged 29% last year, building on the eye-popping advance of 43% in 2023.

The S&P 500 gained a staggering $10 trillion in value last year, according to S&P Dow Jones Indices. Markets have retreated a bit in recent weeks, but Zandi is concerned about a far steeper drop, perhaps exceeding 20%. The Moody’s economist said he hasn’t been this worried about overvalued markets since the late 1990s during the inflating of the dot-com bubble.

Although Zandi isn’t worried about a collapse that is nearly as bad as the bursting of the dot-com bubble, he warns a market drop today would do serious damage to America’s economy. If Americans suddenly saw the value of their investment portfolios plunge, fragile confidence would be hurt. It would erode both the ability and willingness to spend – no small thing in an economy where consumer spending remains the No. 1 driver.

“The run-up in stock values has played a critical role in the economy’s success. It’s driven a lot of spending. The wealth effects are quite potent,” he said. “But if the stock market went down, and stayed down for a lengthy period of time, that would knock the wind out of high-income spending. And that’s a threat to the economy.”

Economists say the overall economic backdrop looks strong to start 2025. Layoffs are low. Inflation has cooled. Paychecks are growing faster than prices. Gas prices are in check.

But David Kelly, chief global strategist at JPMorgan Asset Management, said the “danger” today is high valuations that leave financial markets vulnerable to a sudden drop.

“I’m worried about asset bubbles,” Kelly told CNN. “A lot of castles in the sky have been built on the foundations of this very stable economy.”

In particular, Kelly pointed to high valuations in large-cap US stocks and assets like bitcoin.

“You could have a big correction at some stage in the things that are not tethered to reality,” he said. “There are a lot of very frothy markets out there that could take a shellacking. Investors must think carefully about how much risk they are taking.”

Of course, it’s notoriously difficult to time the stock market.

History shows that stocks that are overvalued can stay that way — or inflate even further — for some time. Consider that some internet companies that didn’t even generate revenue but kept gaining value in the late 1990s before reality set in around 2000.

And betting against this runaway train of a stock market has proven costly. Not even the worst inflation crisis in four decades and the most aggressive Federal Reserve since the days of Paul Volcker could end the ongoing bull market.

Still, cracks have recently emerged in the market and investors are paying closer attention to how reliant the overall market has become on the Magnificent Seven: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.

Consider that the S&P 500’s two-year total return (including dividends) amounted to a very impressive 58% — but that would have dropped to just 24% without the Mag Seven, according to S&P Dow Jones Indices.

US stocks ended 2024 on a weak note and the volatility continued into Thursday, the first official day of trading in 2025.

UBS recently warned its clients that nearly all seven preconditions for a market bubble already exist.

“The problem with a bubble thesis is that when a bubble bursts, investors tend to lose 80% of their money,” Andrew Garthwaite, UBS global equity strategist, wrote in a December 18 report, pointing to the bursting of previous bubbles including the Nifty 50 stocks in the 1970s, in Japan in the late 1980s and the dot-com bubble.

According to UBS, the bubble preconditions that already exist include a gap of at least 25 years from the last bubble, participation among retail investors and profits that are under pressure.

A bubble “happens when there is a narrative of ‘it’s different this time around,’ normally associated with technology or market dominance, and we have both,” Garthwaite wrote.

The good news is that UBS argues the market is “not yet in a bubble” and stocks could “very easily” rally another 15% to 20% before moving clearly into bubble territory.

Still, it is telling that major Wall Street banks are even using the B-word.

Bubble or not, there are countless catalysts that could trigger a market downturn, given how high expectations have been set.

For instance, there is the risk that one or more of the high-flying stocks powering this rally seriously stumbles, taking the rest of the group down. The bar has been set almost impossibly high for this group.

Meanwhile, lawmakers in Washington must eventually figure out a way to defuse the ticking time bomb that is the debt ceiling, which was reinstated on Thursday.

Investors are still trying to make sense of the incoming Trump administration’s economic agenda, which calls for tax cuts, tariff hikes, deregulation and mass deportations.

It’s easy to see how a tariff announcement or dramatic immigration crackdown could unnerve investors on high alert for anything that is inflationary.

But signs of trouble could emerge first in the bond market.

Ed Yardeni, president of investment advisory Yardeni Research, warns that the stock market will get “spooked” if a bond market selloff pushes the 10-year Treasury yield close to 5%.

Yardeni, who in the early 1980s coined the phrase “bond market vigilantes,” said investors will be watching closely to see if Republicans in Congress can address growing concerns about federal budget deficits.

“If they can’t get their act together and only agree to tax cuts, the bond market will freak out,” he said.

Given the extent of the recent gains, it’s only logical that some investors would now be thinking about a potential reversal.

Of course, it’s also possible that rather than drop, markets go sideways. That would buy time for corporate profits to catch up to high valuations.

Yardeni doesn’t see a high risk of a bear market, typically defined as a 20% drop from previous highs, because a recession doesn’t look imminent.

However, he is calling for a 10% to 15% correction.

“I would view it as a buying opportunity, not a reason to panic. That doesn’t meant it won’t be uncomfortable,” Yardeni said.

Kristina Hooper, chief global market strategist at Invesco, said long-term investors should look past a market drop because the overall environment is likely to be positive for stocks and risk assets.

“It’s irrelevant in the grand scheme of things,” Hooper said. “We could see a pullback, but I think it would be temporary and perhaps healthy, preparing the stock market for the next leg up.”