Q4 2025 Commentary
2025 was a rather extraordinary year for equity markets.
A lackluster start to the year turned chaotic in the second quarter with the announcement of the “liberation day” tariffs. The immediate fallout of the tariff announcement was a 10% decline across two trading sessions – a decline only exceeded by the ’87 crash, the Covid-19 panic and the worst days of the financial crisis.
The recovery has been equally phenomenal. In early April, domestic markets closed nearly 20% below their early year highs. By the end of the year, they had mounted a 37% turnaround. That marks one of the strongest intra-year reversals in history – only exceeded after the 2003 tech bubble bottom, the 1980 inflation-crisis lows, and, not coincidentally, Covid-19 and the financial crisis lows.
The immediate reversal can be credited to the fact that tariffs turned out to be far less punitive than threatened. At one point, as trade tensions escalated, the effective statutory tariff rate on imports exceeded 25%. Thanks to deferrals and trade deals, the actual effective tariff rate has been closer to 11%. We are still dealing with the highest tariff rates in generations, and negative effects have been evident among many importers, but markets have generally been graced by positive tariff developments since the April panic.
More relief may be in the horizon. The Supreme Court heard oral arguments in November on an appeals court ruling that found the reciprocal tariffs illegal under IEEPA. If upheld, not only would most of the current tariff structure be dismantled, but importers could be due substantial refunds – a potential tailwind for 2026.
The remainder of 2025’s rally can be credited to the fact that there is much more to the economy than the trade drama. Looking at broader corporate activity, 2025 met market expectations for strong profit growth. S&P 500 earnings grew 15%, accelerating in the second half.
Market optimism was rewarded strongly but faced some resistance to close the year. The S&P 500 was virtually unchanged across the last two months of the year, falling less than 0.1%. The clearest signs of market resistance might be showing up in PE multiples. Before markets flatlined to close the year, the Price/Peak earnings multiple peaked in late October just above 29. That is nearly exactly the multiple at which equities topped out in late 2024, and just shy of the highs set in 2021.
Optimism about future earnings is high, but the lack of multiple expansion indicates that it is not increasing. Analysts are expecting a repeat of 2025’s high-teens earnings growth. If those forecasts hold, it is quite possible that equities put together another solid year of gains. But that is a hefty assumption. The Post-Covid-19 era has marked some of the strongest and most sustained earnings growth in history, and analysts may be getting complacent. Outside of recoveries from earnings recessions, it is rare for S&P 500 stocks to post consecutive years of earnings growth this strong, with probabilities suggesting some level of mean reversion.
Mean reversion to earnings is most threatened by the potential for profit margin compression. Driven by tech companies, profit margins are near record highs, but could face pressures from increasing competition and massive capital expenditures.
If earnings fail to meet expectations, downside risks to equities remain very high. Any sign of a threat to the most optimistic earnings growth expectations could result in a significant pullback. A reversion to the average Price/Peak Earnings ratio of the last 30 years would warrant a nearly 30% decline on multiples alone. As we have reminded clients of these risks in recent years, that is merely a reversion to average multiples, not to cheap valuations.
On the macroeconomic side, there is plenty of conflicting data on the health of the economy, which has only been further complicated by the gap in data from the government shutdown.
The unemployment rate has risen to 4.6%. Excluding Covid-19, that is the highest unemployment rate since early 2017. Nonfarm payroll growth has come in below 110,000 jobs for seven consecutive months – the longest such streak since 2010. Initial jobless claims, however, which often offer a more timely reflection of economic health, have remained quite low for the past several months.
Inflation data suggests some lingering stubborn inflation from the services sector, but year-over-year inflation rates have steadied below 3%. That remains higher than the Fed’s 2% target, but not worryingly so. As we discussed during the inflation boom in 2022, markets tend to handle inflation quite well. What they struggle with are inflation shocks. With tariff implementation and effects relatively muted, we do not see significant upside risks to inflation.
Our opinion may matter less than that of the Federal Reserve. Based on recent data, the Fed has decided to largely abandon the inflation fight. Though many FOMC members have acknowledged a desire for a lower inflation rate, the central bank cut interest rates at each of their last three meetings. Perhaps the more significant move from the Fed was the December end to quantitative tightening. Over the last three weeks of the year, the Federal Reserve significantly increased their balance sheet for the first time since early 2023, ending a multi-year balance sheet reduction of over $2 trillion.
With the economy holding its own and the Federal Reserve on our side, we have felt comfortable increasing our allocation to out-of-favor high quality stocks. Time Overlay account equity allocations have largely been between 30% and 65% throughout the year, and we closed 2025 near the high end of that range.
The last several years have been dominated by mega-cap themes, like FAANG stocks and the “Magnificent 7.” 2025 saw some broadening of equity markets away from these names, but the S&P 500 performance was still concentrated among megacaps. The median S&P 500 stock was only up 5.4% for the year (only 35% of the market return). Over the last three years, the equal weight S&P 500 index has lagged the market cap weighted index by 39%. That is the largest gap in at least the last fifty years. The closest analog came in 1997-1999, leading into the tech bubble peak. We believe this comparison reflects many of the same risks as the tech bubble, but also reflects the same value divergences that saw higher quality, more reasonably valued equities significantly outperform in the subsequent years.
There is no clear end to the current rally in sight, but as evidenced just nine months ago, risk can appear quickly and unexpectedly. The clearest sign of an end to speculative era could be the underperformance of Bitcoin, which ended the year more than 30% from its highs. Since Bitcoin’s peak, gold gained 15% and silver more than 60% (the hard assets gained 60% and 140%, respectively, for the full year). The rotation out of the new speculative currency into the old suggests some shift in market psychology worth monitoring.
We believe that our current allocation has us well prepared to handle any emergent risks in 2026.
As always, we encourage clients to reach out with questions about our positioning or to discuss any changes in your financial circumstances.
Wishing you a happy and prosperous New Year,
Robert B. Drach
Drach Advisors LLC