Elevated Valuations, Enduring Growth

While market performance was strong, returns were not evenly distributed, with a relatively small group of large-cap stocks accounting for a significant portion of the gains. The tech-heavy Nasdaq posted a 2.7% return for the quarter, lifted by continued optimism and capital investment in cloud infrastructure. For the year, the Nasdaq was up 21.1%. Large-cap growth stocks (Russell 1000 Growth) were up 18.6%, while value stocks (Russell 1000 Value) were up 15.9%. Small-cap stocks (Russell 2000) had a positive quarter (up 2.2%) and finished the year with a 12.8% gain.

International stocks meaningfully outperformed the U.S. for the first time in years. Developed market stocks (MSCI EAFE) gained 4.9% in the quarter, bringing the year-to-date return to 31.2%. Emerging markets rose 4.7% (MSCI EM) in the quarter, lifting the year’s return to 33.6%. The decline of the U.S. dollar (down 9.4% in 2025) during the year proved to be a meaningful tailwind for foreign assets.

In the U.S. fixed-income market, the Fed cut rates by 25 basis points in December for the third time this year bring the Fed funds rate to 3.5%-3.75%. The Fed continues to emphasize data dependency, balancing the risks of elevated inflation and a tightening labor market. (We would argue that ‘data dependent’ is an approach that works best when the government isn’t shut down, and the data actually exists.) Against this backdrop, yields moved unevenly across the curve. Credit markets remained strong with spreads near multi-decade tights, and fiscal pressures continue to influence long-term rates. Investment-grade core bonds ended the quarter up 1.1% (Bloomberg U.S. Aggregate Bond), while high-yield bonds were up 1.3% (ICE BofA U.S. High Yield). U.S. core bonds had their best calendar year since 2020—returning 7.3% in 2025.

At the start of 2025, investor expectations were relatively modest, with many forecasters projecting U.S. equity returns in line with projected earnings growth of roughly 8% for the year. As the year unfolded, the market proved far stronger than anticipated, more than doubling start-of-the-year expectations. While projections are usually wrong, and often by wide margins, every December market predictions are rolled out. To be clear, turning the calendar does not magically improve anyone’s ability to look into the future. Yet, here we are again, and 2026 equity return estimates average about 8%, within a wide range shown below. The majority of S&P 500 price return estimates are in the mid-single digit to low-double digit range. Strategists see next year’s growth coming from continued strong earnings growth (low-double digits, on average) while price multiples compress marginally to bring returns down to 8%.

In 2025, the gap between expectations and reality was not the result of a single catalyst, but a combination of corporate profits proving stronger than expected, ongoing significant investment into artificial intelligence (AI), lower interest rates, and labor markets remaining supportive of consumption. The widely anticipated economic slowdown never materialized.

As we close out the year, equity valuations remain elevated. The S&P 500 is trading near 23x forward earnings, well above its long-term average price-to-earnings multiple of roughly 15.6x earnings, meaning investors are paying more today for each dollar of expected future earnings. These higher valuations are being justified largely by expectations for continued economic growth and another year of double-digit earnings growth. Importantly, elevated valuations do not automatically signal an imminent downturn. Over the longer term, however, high valuations do impose gravity on future returns. Historically, when the S&P 500 traded near current levels, subsequent 10-year real returns have averaged closer to low- and mid-single digits, although the number of observable data points is slim. In the near-term, prices may be more sensitive to earnings disappointments or changes in investor sentiment.

Market headlines have largely focused on the strong performance of artificial intelligence-related stocks, and more recently, on concerns that these gains are speculative. This may be true, but this interpretation could be overly simplistic. The adoption of artificial intelligence, automation, and even robotics could reflect a structural necessity rather than a transient trend. After all, the workforce is shrinking, as evidenced by secularly declining labor force participation, not only in the U.S. but across developed economies and increasingly emerging economies such as China.

Looking ahead, current valuation levels suggest an environment in which returns are likely to be driven by earnings durability and cash-flow generation rather than further multiple expansion. Importantly, a greater share of today’s tech earnings growth is supported by tangible, long-term investment rather than financial leverage, distinguishing this cycle from prior periods of elevated valuations. Capital spending remains elevated across AI, energy, and infrastructure as corporations and governments respond to demographic headwinds and labor scarcity. While cyclical risks remain, these multi-year investment commitments may help anchor growth and reduce the likelihood of a traditional recession, which are typically characterized by a broad pullback in capital spending and increased unemployment. In this environment, elevated valuations reinforce the importance of selectivity, diversification, and a focus on companies with durable earnings power and strong balance sheets.

One of the defining features of this cycle has been the failure of several historically reliable recession indicators. Investors who relied on traditional shortcuts or macro rules of thumb that worked with empirical regularity for decades have been persistently positioned for a downturn that never arrived.

A prime example is the inverted yield curve. Historically, a sustained inversion of higher short- and lower long-term Treasury yields reliably preceded recessions, reflecting restrictive monetary policy and deteriorating growth expectations. While the curve inverted deeply and for an extended period in this cycle, the predictive power of indicator broke down. As we mentioned in prior commentaries, the inverted curve occurred alongside a period of very negative real Fed funds rates, which we felt implied an accommodative Fed, and therefore we put less weight on the yield curve signal. The signal was there, but the economic meaning changed.

Similarly, the Conference Board’s Leading Economic Indicators (LEI) fell to levels that historically coincided with recession. Yet the expected contraction never materialized. Much of the decline in LEIs reflected interest-rate-sensitive components and manufacturing weakness, areas today that are less representative of an economy that is increasingly driven by services and technology investment. The LEI downturn proved more indicative of a traditional industrial slowdown than a broad-based economic slowdown.

The broader takeaway is not that these indicators are “broken,” but that they are incomplete in a cycle shaped by non-traditional structural forces such as AI-driven capital investment, significant fiscal stimulus, and shifting labor dynamics. Investors who relied exclusively on historical shortcuts and got defensive misdiagnosed the environment and mis-positioning portfolios.

Looking ahead to 2026, our outlook remains constructive, with real GDP growth expected to range between 2.0% and 3.0%, supported by consumer spending and an ongoing investment cycle tied to infrastructure, energy, and productivity-enhancing technologies. While AI-related investment has been a major contributor to recent growth, we expect its pace to slow from the exceptionally fast levels seen over the past two years.

We expect market leadership to broaden as the outsized performance of large-cap stocks begins to moderate. Smaller-cap and value-oriented segments supported by earnings recovery, operating leverage, and more attractive valuations could attract increased investor interest if economic growth remains steady and financial conditions ease modestly.

Credit fundamentals remain sound. Lower policy rates, albeit incremental, should ease refinancing pressures and support corporate balance sheets, with returns in fixed income increasingly driven by income rather than price appreciation. A gradual steepening of the yield curve, led by declining short-term rates, would be consistent with slowing but healthy growth and inflation modestly above target.

More broadly, this cycle has challenged many traditional economic and market frameworks. Signals that have historically predicted recessions such as an inverted yield curve, weak leading economic indicators, and rising unemployment have so far failed to produce the expected recession. While these indicators should not be ignored, relying on them in isolation may prove less useful in an environment shaped by demographic constraints, constrained labor supply, and sustained capital investment. In such a regime, flexibility, diversification, and a focus on underlying fundamentals remain more valuable than adhering to historical rules of thumb.

We thank you for your continued trust and partnership. Wishing you a healthy and prosperous 2026.