The bull market continues! Morgan Stanley forecasts the US stock market to reach 6,500 points by the end of 2025, with a preference for high-quality cyclical stocks

Morgan Stanley believes that with the Federal Reserve expected to cut interest rates next year and continuous improvement in business cycle indicators, the momentum of profit growth will continue to expand in 2025. A "bull market scenario" is unfolding, raising the target price for the S&P 500 index to 6,500 points by the end of next year.

Based on Tuesday's closing price, this implies a 7.9% upside potential for the S&P.

The report also states that considering the external macro environment remains uncertain, U.S. stock valuations may fluctuate throughout next year, depending on the impact of new policy measures, interest rate trends, and geopolitical dynamics.

By sector, Morgan Stanley believes that fundamental trends and policy inclinations will long-term benefit high-quality cyclical stocks, while also being optimistic about the performance of the financial, industrial, and software sectors.

S&P to reach 6,500 points next year, but the process will not be "smooth sailing"

Previously, in the mid-year outlook report, Morgan Stanley believed that under the most optimistic "bull market scenario," the S&P would reach 6,350 points by mid-2025, mainly benefiting from continued fiscal stimulus driving profit growth.

On November 18, Morgan Stanley's U.S. equity strategist Michael J. Wilson and his team released the latest research report, providing an outlook for the U.S. stock market in 2025. Morgan Stanley stated that the "bull market scenario" envisioned mid-year is unfolding, considering that the volatility of inflation has significantly increased post-pandemic. The increased uncertainty of economic data and policy combinations has allowed high-quality stocks to continue outperforming the market, making high-quality indices like the S&P 500 the biggest beneficiaries.

The report explains that this is mainly because, in a relatively restrained fiscal policy environment, investors urgently need assets that can outperform inflation, which is one reason why gold and certain cryptocurrency assets are performing well.

From the perspective of political variables, Morgan Stanley believes that in the case of a Republican victory, the corresponding trading pricing is underestimated, and there is expected to be more upside potential as we enter 2025.

The report also states that the current rise of the S&P has paused, considering that the market is overbought, new policies still have uncertainties in terms of sequencing and specific intensity, and recent statements from Federal Reserve Chairman Jerome Powell have not shown a clear "dovish" stance. The market may need to see more positive growth data to reach the target price of 6,500 points.

Morgan Stanley believes that from now until the end of 2025, market performance is unlikely to rise straight up, and next year the market will rotate between various macro outcomes (similar to the situation in 2024).

The Biggest Market Variable Under Trump 2.0: Fiscal Policy

Morgan Stanley believes that among the policy combinations that Trump 2.0 may introduce, the variable with the greatest impact on the market and the most difficult to determine is the measures to cut fiscal spending, specifically how the newly established Department of Government Efficiency (DOGE) will lead the reduction of government expenditures.

The report states that considering the current government debt exceeds 120% of GDP, with a "explosive" expansion of debt increasing by $1 trillion every 100 days, it makes sense for DOGE to "adopt a more open attitude."

On this basis, U.S. Treasuries, as the main trade betting on the Republican victory, will pose potential risks to the stock market.

Morgan Stanley explains that as the market may begin to consider the ability of the Trump administration and Congress to address the fiscal deficit in the coming years, the term premium will be a key indicator to observe the bond market's response. The report states that if U.S. Treasury long-term yields rise by another 20-50 basis points, it could have a substantial negative impact on stock price-to-earnings ratios.

The report also adds that it is noteworthy that the term premium of bonds did not rise significantly after the election, which may be a small sign indicating that the bond market may not be as concerned about the deficit expansion brought by a Republican victory as initially thought, though time will tell whether this dynamic will persist.

Morgan Stanley states that the most encouraging signal for the market currently comes from "the ratio of real returns on stocks to gold," which has been consolidating for years but has significantly risen from support levels since the election results were announced. The report claims that the market is beginning to consider that a fiscal-led and crowding-out effect shift may bring broader and more positive real returns.

Although it is still too early to draw conclusions, Morgan Stanley also states that one thing is certain: policy matters, and compared to immigration and tariff policies, the market is clearly more interested in deregulation and potential fiscal policies at present.

Preferred High-Quality Cyclical Stocks, Favoring Financial, Industrial, and Software Sectors

The report states that considering the prospects for a subsequent easing of the regulatory environment and a potential rebound in market sentiment will become clearer, under the favorable conditions brought by the Federal Reserve's interest rate cut cycle and stabilization of business indicators, high-quality cyclical stocks are expected to rise further.

Morgan Stanley defines "high-quality cyclical stocks" mainly based on the following criteria: stocks ranked in the top 1000 by market capitalization, stocks with a quality composite score above the median, classified as cyclical stocks under the firm's classification standards, and rated "overweight" by the firm. Morgan Stanley believes that although the fluctuations in yields have been suppressed so far, interest rates will remain an important focus in the future, which has led to strong performance in cyclical stocks and driven the market higher.

Secondly, Morgan Stanley is optimistic about the performance of financial stocks, mainly due to accelerated capital activities, relatively reasonable valuation levels, and expected regulatory easing that will drive performance growth.

In addition, the report suggests that the industrial sector will benefit from the manufacturing reshoring trend advocated by the Trump administration, which also belongs to cyclical stocks and is expected to achieve strong and sustained growth, with Morgan Stanley particularly optimistic about the electrical, automation, and distribution industries.

Software stocks, which have long lagged in the technology sector, seem to have bottomed out. Morgan Stanley believes that although corporate technology spending budgets have increasingly shifted away from software models over the past two years, leading to a slump in software company stock prices, currently, as profitability gradually recovers, more and more software companies have achieved positive free cash flow.

The report states that after the election, strong business confidence may return, which should also help stimulate a stronger spending environment in 2025, benefiting the software industry.

The report also suggests that potential incremental tariffs and limited pricing power may continue to pressure non-essential consumer goods stocks, and the negative correlation with interest rates and weaker relative earnings revisions have led the firm to maintain a neutral stance on small-cap and large-cap stocks.