4 things need to happen for the stock market to continue its record rally in 2025

• For the S&P 500 to sustain gains into 2025, four factors need to align, says LPL Research.
• LPL Research notes that avoiding a recession and a dovish Fed are crucial for continued stock market growth.
• Trump's policies could be the deciding factor, as some of his policies could impact markets both negatively and positively.

As the stock market wraps up a second straight year of 20% gains, the bar is high for the rally to continue into 2025.

"Investors will have to grapple with a market pricing in a lot of good news," LPL Research said in a note this week. "Positive surprises that drove stocks higher in the last year may be more difficult to come by in the year ahead."

According to the firm, stocks can extend their record rally into next year if four important factors align.

Recession avoided

It may seem obvious, but for the stock market gains to continue, the economy needs to stay resilient, and that means the US needs to sidestep a recession again in 2025.

Historical data suggests the third year of a bull market can be solid, printing average gains of about 5%, according to LPL. But that's only if a recession is avoided.

"In the absence of a recession, the odds that a two-year-old bull market gets to three are quite good," LPL said. "The bulls that didn't make it through a third year were ended by recessions, an overly aggressive Fed, or, in the case of 1987, excessive speculation."

With US GDP tracking at an annualized growth rate of about 3%, it seems only an external shock could jolt the economy significantly lower. One economist even gave a 0% chance of a recession for next year.

A dovish Fed

Stocks have seen a surge in downside volatility since Fed chairman Jerome Powell issued a somewhat hawkish interest rate cut at the central bank's FOMC meeting earlier this month.

But it's important to note that the Fed is still dovish, according to LPL.

"LPL Research's base case remains for at least two cuts next year as inflation comes down further, which should be good for stocks," the firm said.

While rate cut expectations for 2025 moved lower, the Fed is still on track to lower borrowing costs.

And absent a recession, the S&P 500 has historically delivered solid returns after a Fed-cutting cycle.

"The S&P 500 has produced modest gains of 5.5%, on average, during the 12 months following the initial cut of a Fed cycle, with gains typically double that in the absence of a recession," LPL said.

The Fed delivered its first interest rate cut of the cycle in September.

This isn't the first time markets have experienced volatile trading due to a recalibration of interest rate expectations.

Heading into 2024, markets were expecting more than six interest rate cuts from the Fed. They only delivered three rate cuts, including a 50-basis point jumbo cut. The stock market ultimately did just fine.

Strong earnings growth

Corporate earnings are the driving force behind rising stock prices in the long term, so it should be no surprise that LPL is watching for continued earnings strength in the new year.

"When valuations are as high as they are currently, earnings growth is typically required to lift stock prices. Expect 2025 to be one of those years," LPL said.

Corporate earnings could grow more than 10% in 2025, which should be sufficient for rising stock prices.

LPL said the key factors behind solid earnings growth next year include a steady economy, limited wage inflation, productivity gains from AI, and a wave of deregulation.

"LPL Research's forecast for S&P 500 earnings per share in 2025 is $260, in line with the long-term average earnings growth rate near 10%, but below current consensus estimates near 15%," the firm said.

Upside from Trump policies

With the incoming Trump administration, there will be a shakeup in Washington.

LPL just hopes there's more upside than downside to some of President-elect Donald Trump's proposals, including tariffs, lower taxes, and big cuts to government spending.

"We believe markets are correct to expect deregulation to support certain industries, including financial services and oil and gas, and to help foster more merger and acquisition activity," LPL said.

But tariffs are a looming threat, as historically protectionist trade policies "put the 'Great' in the Great Depression," the firm noted.

Potential tax cuts also seem less promising than Wall Street might think. The Republican party has a slim majority in the House to pass such legislation, and even if passed, they wouldn't go into effect until 2026.

"We don't believe Republicans, with a slim majority in the House, will find enough offsetting spending cuts to get any meaningful reduction in corporate taxes," LPL said.

"Bottom line, for stocks to enjoy a good year in 2025, policy from the Trump administration will have to deliver more benefits than costs."