'Due for a full-blown correction': Why one CIO expects a 15% stock-market pullback early in 2025 — and how to prepare

• Don't expect the market to continue skyrocketing in 2025, according to David Laut.
• Periods of high consumer sentiment have often been followed by market pullbacks historically.
• Prepare for pullbacks by keeping your cash in a short-term bond fund, Laut said.

As the year draws to a close, investors typically anticipate the so-called Santa Claus rally — a phenomenon where stocks get a boost in the final days of December and the beginning of January.

However, the year-end rally has been lackluster, with stocks drifting lower in the days after Christmas. The Nasdaq 100 is down nearly 5% from its peak, and Big Tech companies like Nvidia, Tesla, and Microsoft all posted declines in share price last week. Stocks continued their slump this week, with the Nasdaq 100, Dow, and S&P 500 indexes all falling over 1% within the first hour of trading on Monday.

This lackluster stock market performance could be foreshadowing what's to come in the new year, according to David Laut, chief investment officer at Abound Financial, who sees a pullback in the cards.

"While we are staying invested in stocks, we would not be surprised to see an early 2025 pullback of as high as 15%," Laut told Business Insider in an interview. "The last time we saw a correction of over 15% was during the 2022 bear market and volatility, so we are due for a full-blown correction."

Priced for perfection

Valuations and investor expectations for stocks are high going into the new year, making the market vulnerable to any negative news, according to Laut.

And as Laut sees it, things are only getting worse as investors continue to be tempted into the market as the fear of missing out, or FOMO, kicks in.

"It's that 'late to the party' piece starting to set in," Laut said.

"It's going to be about investing at the end," Laut added, making a distinction between investing based on fundamentals and speculation. "One piece of bad news, and then it's just panic."

A higher-than-expected inflation report, increased unemployment numbers, or an unsatisfactory Nvidia earnings call — these could all trigger a sell-off in the market, Laut believes. That's not to mention the uncertainty regarding political policy as a new president enters the White House in January.

Investors are already seeing this to some extent. Laut pointed to the market's reaction to the Federal Reserve's rate cut decision last week as an indicator of how tenuous valuations are now — the S&P 500 dropped 3% after the market learned that two, not four, rate cuts were in the cards for next year.

Ed Yardeni, president of Yardeni Research, agrees: positive investor sentiment is a contrarian indicator that signals a correction. Investors piling into stocks could signal emotional investing and a market top. Yardeni also believes that a stock-market pullback is in the cards early next year.

There's certainly a recent precedent for holding such a belief. After all, the market saw an August drawdown of 8.5% from July highs earlier this year after unfavorable economic reports dampened investor confidence. And after a 106% rally following March 2020 lows, stocks kicked off 2022 by falling 25%.

"When the market's way up, catalysts from a risk-reward perspective are going to be skewed to the downside, at least in the short term," Laut said.

Preparing for a pullback

Investors shouldn't panic about a potential correction. In fact, it could be a chance to grab stocks at discount prices. The key is to not rush into the market at frothy valuations, especially if stocks have a year-end rally, Laut said.

"If you want to put money to work, be patient because you're going to have an opportunity," Laut said. "FOMO is not your friend when it comes to investing."

Laut points out that it's typical to see pullbacks in the S&P 500 every 18 months or so. Investors can prepare for this by letting excess cash sit in short-term bond funds instead of a money market fund and buying in when the market experiences a decline, he said.

"If the market pulls back 15% every 18 months, well, right now, short-term bond funds have about an 18-month duration," Laut said. "So why not earn 5% and wait for a good opportunity?"

Examples of short-term bond funds include the SPDR Portfolio Treasury ETF (SPTB), the Vanguard Short-Term Treasury Fund (VFISX), and the Invesco Short-Term Treasury ETF (TBLL).