Q2 2025 Commentary
It was a whirlwind quarter for stocks.
Just two days into the quarter we were confronted with a tariff shock, as the Trump administration announced surprisingly draconian import duties across the globe.
Stocks reacted by falling more than 10% across just two trading days. The selloff was among the steepest two-day declines in history, surpassed only by the 1987 crash, the Covid-19 shutdown, and the worst moments of the financial crisis.
Turmoil was also evident in bond markets and currency markets, where volatility spiked and the dollar saw notable devaluation.
The instability prompted the administration to pause most of the tariff hikes for 90 days. Markets rallied on the news, with the S&P 500 staging a 10% intraday reversal – a move even more historic than the loss that preceded it. By late June, markets had fully shrugged off tariff fears (as well as a U.S. debt downgrade and Middle East tensions) to close at new all-time highs.
We were able to address the initial selloff in last quarter’s commentary, noting that the extensive panic created some buying opportunities. Our Time Overlay strategy accounts increased equity exposure to nearly 50%, but in light of the rapid recovery, we quickly reduced equity exposure back below 40% -- largely where we began the year. Our conservative stance has allowed us to escape most of the volatility.
While markets are celebrating new highs, the renewed optimism overlooks the tumultuous path that got us here. The S&P 500 closed the quarter 28% off of its low, but less than 1% above its pre-Liberation Day high, which was set in February – not a particularly impressive four months.
While investors have found relief in the rally, it is not clear that the turmoil is behind us. The 90-day tariff extension came to an end prior to the publishing of this commentary. This deadline was met with a yawn as additional tariff implementation was pushed out to August 1st. As we see more details about the August 1st tariffs, they are looking no less punitive than the April levels. If implemented, these tariffs may not trigger another April-style selloff, but they will almost certainly weigh on markets.
Among the reasons that markets have been able to handle the trade uncertainty has been the resilience of the domestic economy. The unemployment rate has been steady, settling between 4.0% and 4.2% for more than a year. Job creation has held firm, with the economy adding between 100,000 and 150,000 new jobs in each of the last six months.
Inflation cooled in April and May, bucking the fears of tariff critics and raising some dovish sentiments from FOMC members.
But there are also plenty of signs of economic weakness that would temper optimism in a more rational market. In June, the 4-week moving average of initial jobless claims rose to its highest level since 2023. Continued claims, meanwhile, rose to their highest level since 2021. Retail sales have been weak, declining notably in May. Broader measures of economic activity show continued growth, but at a decelerating pace.
On the inflation front, the encouraging April and May data was followed by a hot June report – eroding some hopes of a July rate cut. Though most inflation data was merely back to levels we saw earlier this year, Core “Sticky” inflation saw its largest monthly jump since September 2022.
None of this economic data is significantly concerning, but it is not the type of data that generally sustains a strong bull market.
It is certainly not the type of data that warrants today’s historically high P/E multiples. The price/peak earnings multiple closed the quarter back above 28. That is a level that has only been reached three times: during the dotcom bubble, during the 2021 tech bubble, and earlier this year – all instances that were followed by notable declines.
Signs of complacency extend beyond equity multiples. We are seeing similar signals from long-term corporate bond spreads, which have fallen back to early-year levels (which reflect multi-year lows). We are also seeing retail investors embrace the risk, as they have resumed massive inflows to equity funds, and now have the largest equity allocations in history (according to EPFR data).
Like much of the price action in recent years, the recent gains have been concentrated among the largest companies.
According to data compiled by Ed Yardeni, “Magnificent 7” stocks, which make up more than 1/3 of the S&P 500’s market cap, are trading at a forward P/E of more than 28. The large-cap-universe overall trades closer to a forward P/E of 22, a 20% discount. Small- and mid-caps, which spent the first 20 years of this century trading at a premium to large caps, are trading near a forward P/E of 16 – in line with historical norms, but at a 40% discount to Magnificent 7 stocks and a 25% discount to large caps in general (a gap last seen during the late 1990s tech bubble).
The levels of pricing dispersion within the market indicate that there are opportunities that do not involve chasing stocks at dramatic premiums to historical norms. This dispersion is part of the reason that we are comfortable owning the equities at the levels that we do, concentrated in relatively out-of-favor high-quality stocks.
Entering Q3, we remain attuned to increasing cash allocations. While we don’t expect a repeat of April’s extremes, markets face significant headwinds from tariffs, valuations, and economic crosscurrents. We remain well-positioned for this uncertainty, focused on high-quality opportunities while maintaining liquidity to capitalize on dislocations.
Robert B. Drach
Drach Advisors LLC