Q3 2025 Commentary

At this time last year, equity markets were riding a wave of optimism on the way to a 27% annual gain.  Part of that gain was driven by solid earnings growth (at just over 9%, S&P 500 earnings growth was above average), but two-thirds of the market gains were driven by optimism about the future, as reflected in rising P/E multiples.

Stocks ended the third quarter of last year at a P/E multiple of 28. At the time we noted that optimism of this magnitude has never justified the risks, and has always been followed by notable losses (a common refrain in this commentary in recent years). This observation put us decisively at odds with market optimists.

Both we and the optimists have been vindicated over the past year. S&P 500 earnings have grown at a double-digit pace, validating market appreciation in the eyes of many. But the excessive risks were also realized in the form of a 20% decline between the February highs and the April lows, which quickly wiped out over a year's worth of gains. The rebound since has been historic, bringing equity multiples right back to last year's elevated levels - and by some measures, even higher.

Our preferred measure, the price/peak earnings multiple, assumes that current earnings are valid and sustainable. These are the earnings that companies have been able to generate, offering a solid baseline for valuation. By this measure, we are back where we were late last year, approaching levels only exceeded at the most extreme market peaks. The price/peak earnings ratio hit 30 in 2021 and peaked near 33 in 1999.

By several other measures, we have reached dotcom bubble valuations. We can dismiss many of them as overly conservative (price/book, the Shiller CAPE ratio), but the price/sales ratio, which offers a timely, yet less manipulable measure, might offer the most sober assessment.  By this metric, the S&P 500 has recently surpassed tech bubble valuations.

The common justification for the S&P 500’s price/sales ratio, now above 3.3, rests on the strong profit margins of tech giants, which average 30-40% versus the index’s 12%. Yet, the nature of the AI boom itself raises questions. Hyperscalers’ relentless AI spending is fueling fierce competition, risking oversupply and margin pressures. Should AI drive broad efficiencies, smaller firms and informationally efficient consumers may further erode profits, casting doubt on the high-margin foundation that supports today’s elevated valuations.

If capitalism functions as it is supposed to, it may not be so different this time.

Beyond the concentration of optimism in a handful of expensive technology names, we continue to see signs of speculative excess across markets. While the current environment features fewer profitless companies than the dotcom bubble or even the 2021 peak, speculation has found other outlets. Retail investors are gambling on zero-day-to-expiration options. Three-times leveraged ETFs tracking individual stocks are proliferating. Crypto platforms now offer 50x leverage on perpetual futures contracts. The expanded use of options and the mainstreaming and securitization of cryptocurrencies – assets that produce no earnings and no cash flows – has in many ways replaced the role that profitless technology stocks played in prior bubbles.

Outside of the AI-driven enthusiasm, little in the broader economy justifies today’s rich valuations. The macro backdrop remains solid but unspectacular.  We do not have the latest macroeconomic data thanks to the ongoing government shutdown, but the last BLS employment report showed the highest unemployment rate since 2021, and four consecutive months of sub 100,000 job gains – the longest streak since 2010. In place of federal data, the best employment gauge may be the ADP private payrolls report.  This number has been even more discouraging, showing private-sector job losses in three of the last four months.

Progress on inflation, meanwhile, has stalled.  Most inflation measures have remained sticky, lingering closer to 3% than the Fed’s 2% target.  If there is anything encouraging from the inflation data, it is that it is not worse, as tariff impacts have been softer than many feared. 

The weak labor numbers, combined with “better than feared” inflation data, gave the Federal Reserve cover to cut interest rates last month.  There is a fair debate as to whether the Fed’s reluctance to cut rates has been prudent (inflation remains high) or whether they are behind the curve (labor market is weak).  We are not particularly beholden to either view, but the recent rate cut comes on the heels of strong consumer spending data and signs from jobless claims that the labor market may have already turned a corner.

Markets (and the Fed) may have gotten ahead of themselves, placing near certain odds on two more rate cuts before year-end.  If the FOMC follows through on these expectations and the economy proves to be truly resilient, these rate cuts could add to inflationary pressures as we enter 2026.

The economy also faces continued inflationary threats from tariffs.  A combination of delayed implementation and corporate cost absorption has minimized the tariff impact to inflation so far, but the next “deadline” for a trade deal with China is November 10th, after which tariffs on Chinese goods could theoretically rise from 30% to 145%. We do not expect these punitive tariff rates to go into effect, but the deadline is a reminder that it is unlikely that trade war effects are truly behind us.  Companies will absorb tariff costs only as long as they must. As soon as consumers can afford to bear the burden of tariffs, they most likely will.

Importers, who have been shouldering much of the tariff costs, are hoping for some relief from the Supreme Court.  An appeals court has already found most of the Trump administration tariffs to be illegal, and the Supreme Court will hear arguments in early November.  If the “reciprocal” tariffs are indeed found to be illegal, not only will it offer tariff relief, but importers will be due over $50 billion in tax refunds – a not insignificant level of direct fiscal stimulus.

Despite major market swings, our core Time Overlay strategy has only made small adjustments to our equity exposure over the course of the year. Time Overlay accounts ended the third quarter less than 40% allocated to equities – largely where we started the year.  Our ongoing exposure reflects our belief that opportunities for prudent investment still exist, even when broader indices appear expensive.

The performance of our Time Overlay strategy reflects our sector positioning and our refusal to chase the most expensive segments of the market. We remain comfortable with this trade-off. In environments where downside risks are elevated, we prioritize the preservation of capital and the ability to act opportunistically.

Despite our worries and positioning, there is a strong possibility that this market has more room to run.  As noted above, past euphoric cycles have seen price/peak earnings multiples exceed 30x. Though we do not necessarily expect market to reach those levels, past cycles have seen multiples peak before prices do, and multiples were setting highs right up until the end of the quarter. 

We cannot be complacent, however. The fact that markets can become more expensive does not mean they should, nor does it eliminate the downside risks associated with elevated valuations. We continue to believe that patience and prudence will be rewarded. Whether that reward comes from deploying capital into future dislocations or from holding discounted businesses through volatility, we are positioned for either path.