Domestic Equity Market Commentary – 4Q 2025

While a sluggish December was barely able to extend the market’s post-Liberation Day winning streak to eight months, stocks nonethe-less posted another solid return for the quarter. Continued economic growth, strong corporate earnings, two Fed rate cuts, and heavy AI spending were the primary drivers of market performance. The S&P 500 gained 2.7% for the quarter, pushing its full-year return to 17.9%. However, only two sectors, Health Care and Communication Services, posted quarterly returns ahead of the Index. Healthcare stocks were particularly strong, driven by gains in several pharmaceutical stocks, especially Eli Lilly on the strength of its GLP-1 franchise. Google par-ent Alphabet was up strongly on the successful launch of its latest AI model, generating essentially all of the gain in Communication Services.

The Russell 2000 Index rose a respectable 2.2% for the quarter, trail-ing the S&P 500 by just 50 basis points, and finished the year with a 12.8% gain. While this is its third consecutive double-digit gain, it also represents a record-tying fifth consecutive year of underperformance versus large cap stocks. Only three sectors beat the index return in the quarter, while the Health Care sector was broadly responsible for all of the gain, driven by favorable clinical trial activity, several drug approvals and acquisitions among stocks in the biotech and pharmaceutical industries. Education stocks in the Consumer Discretionary sector were particularly weak on disappointing fundamental news, while the IT sec-tor also declined on weakness by both cryptocurrency and quantum computing stocks. Despite the weakness among these retail-favorite industries, lower-quality style factors including small size, low ROE, and non-earners again outperformed.

Value stocks regained their momentum versus Growth in the quarter, although it was not quite enough to reverse Growth’s full-year advantage. Large cap Value was 2.7% ahead of Growth in the quarter, cut-ting Growth’s lead in half to 2.7% for the full year. Among small caps, Value outperformed Growth by 2.2% in the quarter, cutting Growth’s lead to only 0.4% for the year.

Entering 2026, the outlook for the economy and equity markets remains quite solid. Corporate earnings growth, while stalling slightly in the quarter during the government shutdown, now looks poised to accelerate into the new year. Consensus Wall Street expectations are for low-teens earnings growth among large cap stocks. Economic growth should be driven by the beneficial impact to both consumers and businesses of the “One Big Beautiful Bill” tax cuts and deductions, regulatory easing, continued broad and aggressive AI spending, and likely two more rate cuts by the Fed. Corporate balance sheets remain healthy, providing ample firepower for share buybacks, dividends, and acquisitions. Personal balance sheets also remain strong, no doubt helped by record stock market levels and home price appreciation, providing a continued tailwind for spending and investment. We are nonetheless cognizant of several risks to this outlook, including an imminent decision by the Supreme Court on Trump’s tariffs, a soft-ening labor market, the still sluggish manufacturing economy, weak Consumer Sentiment indicators despite resilient spending levels, and rather suspect AI funding arrangements.

Despite the rising market, equity valuation levels have remained steady due to the increased level of earnings. The S&P 500 continues to trade at just under 23x earnings. While the P/E ratio is still high by historical standards, its earnings yield of 4.4% is back to a modest premium to the 10-year Treasury’s 4.1% yield. Smaller cap stocks trade at more reasonable valuation levels, and their improving earnings growth rate, likely to exceed that of larger caps, suggests they will be beneficiaries of broader economic growth. We are optimistic that this is setting the table for broader stock market participation and a reversal of the small cap stock underperformance of the past several years.

With our commitment to building high-quality portfolios selling at reasonable valuation levels, we were somewhat pleased to see weak-ness among the more speculative, retail investor favorite industries in the fourth quarter. As stated last quarter, we have no doubt that many future winners will come from these emerging industries. And indeed, we have placed our bets in several names in these industries. But they must meet our criteria of confidence in management’s capabilities and business fundamentals, as well as reasonable equity valuation. This approach should allow us to participate in upside opportunities while still offering downside protection to our clients.