Quarterly Perspective for 3Q.25

Quarterly Market Summary

Summary

The stock market rally continued, with the S&P 500 adding another 8.1% last quarter to bring its year-to-date gain up to 14.8%. Once again, technology was the leader, as its 13.2% quarterly gain was driven by sky-high aspirations for growth in the artificial intelligence trade(AI) sector. The only declining sector was consumer staples (think Pepsi and Procter & Gamble), which posted a -2.4% loss. The AI boom is mainly lifting technology stocks (especially those that produce the semiconductor chips that power the search for greater intelligence), but it’s also the boosting the utility stocks that provide the power, the real estate stocks that provide the land where data centers are built, the industrial stocks that build the plants and cool them so they don’t overheat, and the financial stocks that raise the money for all of this. There is a certain gold rush mentality in the stock market right now, which is exciting but also increasingly concerning.

Emerging markets outpaced both U.S. stocks and foreign developed markets stocks last quarter. China was especially strong as its government provided significant support to its technology sector. Knowing that cutting-edge semiconductor chips from Nvidia would no longer be available because of trade restrictions, China has gone “all-in” on producing its own. Many of the best performing foreign markets this year have been in the emerging area - Vietnam, South Korea, Poland, and Peru – are each up more than 50%. That’s why you diversify. 

Bonds added another two percent last quarter, bringing their year-to-date return to 6.1%. When interest rates started to soar in early 2022, investors found that they were better off in money market funds than in bond funds because the latter was more volatile yet returned less because of inflation. That hasn’t really been the case over the last 12 months; the promise of interest rate cuts has invigorated the bond market as money market yields have fallen. High-yield bonds have risen 7.2% this year, nicer than Treasuries, but maybe not enough extra yield for the added risk. So far this year, global bonds have continued to be the top performers. Emerging market debt rose another 4.3% last quarter and is up close to 11% year-to-date. Municipal bonds have been the weakest sector of the bond market this year, but they finally began to perform in August and finished the quarter up 3.1%.

All the above paled in comparison to the stellar gains from the gold sector. Gold bullion soared 16.4% last quarter due to several factors, including global central bank demand and fears about U.S. interest rates and trade policy. Gold mining stocks, which can be considered leveraged investments tied to gold price movements, experienced a 43.8% increase in the last quarter. Gold is a very volatile sector, so it is essential to make changes incrementally.

Activity

Risk-taking was clearly in fashion last quarter as stocks in select niches like quantum computing, uranium mining, and cryptocurrency staking made large moves. There isn’t much one can do in an environment like this – we are not going to chase stocks in companies that are just starting up and hardly even have revenues (let alone profits). We were more interested in weeding out some underperformers (stock funds that leaned too heavily into real estate, health care, energy, or consumer staples) than making any major changes. Sometimes it pays to buy what is cheap and out of favor, but this past quarter was not such a time. On the bond side, in addition to extending the duration to benefit from declining interest rates, we also reduced floating rate exposure because lower rates mean lower yields.

Outlook

Historically, September is a difficult month for stocks.  Market started to anticipate this by flattening out in mid-August, but positive interest rate news sent the market soaring again after Labor Day.  I have learned over decades in this business to be nervous when investors get this ebullient, but I know I’m never get the exact timing of a market top.  If one leaves the party too early, one can miss a lot. The S&P 500 has provided outstanding returns since 2012, so if one is going to go against the big technology names that lead this index, one better be very sure of both their thesis and their timing (and I am not).  I just know that trees don’t grow to the sky.  A couple of charts of hot sub-sectors show just how far and how fast we’ve run up:

Semiconductors are up over 92% since April 8th. They are a key component in Artificial Intelligence, but still … 92% in six months?

I am not averse to investing in these sectors (we already do, to some extent).    In fact, I believe that the two interest rate cuts we expect this year meaningfully reduces the chance that the “tech reckoning” happens in 2025.  If this sounds too bearish remember this: the bursting of the technology bubble in 2000 led to a half-decade of great returns for the small company and financial/real estate sectors because the fallout led to sharp decline in interest rates.  I’m starting to become bullish about non-technology sectors. When it comes to the financial markets, someone’s pain is often somebody else’s gain. 

Commentary

Since I’ve suggested that technology may not be a leading sector going forward, I owe you a good discussion of why I feel this way. You will recall that last quarter when I described the dramatic outperformance of growth over value in recent years I did not suggest that I saw an imminent end to that.[1] The stock market can and often does remain overvalued for prolonged periods of time if liquidity conditions are favorable. If investors don’t get carried away, nice gains can be had for years.  However, as happens every so often, investors decided they wanted to discount future earnings all at once.  Several years of anticipated AI profits in different areas of the economy were priced in. This is making it exceedingly difficult to justify what is going on without making comparisons to earlier pre-crash periods like 1987 or 1999 or 2021.

Here are my main areas of concern:

1.       Valuation – A Nice Increase in Earnings Growth Has Gone a Long Way

This chart shows how the market is turning modest corporate profit increases into large price gains. 

2.       Relative Strength – Piling Into Today’s Winners Can Be a Risky Strategy

Relative strength is a measure of how strong the price performance of an asset is versus its peers. Theoretically, one wants to own assets that are over-performing and to avoid those that are under-performing.  At a certain level of over- or under-performance, however, the trend is usually unsustainable; nothing soars or plunges forever. The market uses a measure called RSI to determine good over-performance (recognition of competitive advantage) versus dangerous over-performance (assertions that said company “owns the future”). An RSI over 75 suggests the stock or ETF is doing so much better than the overall market that a period of “consolidation” - at the very least - is likely.   Wall Street has a maxim: “Pigs get fat, hogs get slaughtered” to warn against feeding too heavily at the trough, so to speak.

3.       Increasingly Lower Free Cash Flow - Not All Great Businesses Today Will Be Great Businesses Tomorrow

Investors typically love free cash flow, which is defined as the cash a business has left over after all expenses (including taxes and dividends) are paid, PLUS any spending required to maintain the current level of profitability (in other words, depreciation). The more the hyper-scalers (Meta, Amazon, Microsoft, and Alphabet) are forced to spend just to keep pace in the AI race with their rivals, the less they have for dividends, stock buybacks, or acquisitions.

One of the biggest attractions these stocks had up until recently was that they were huge free cash generators. As such, they commanded price-to-earnings multiples of over 30 times (while for the average stock, the P/E multiple is less than 20). If they continue to have to spend gigantic sums on their AI buildouts, they deserve lower P/E multiples[1].  This implies that their current stock prices are too high.

4.       Quality – Lower Quality Companies Tend to Outperform Before Market Peaks

Quality, as a stock attribute, sounds like something you definitely want. It is usually defined as having a strong balance sheet, strong cash flow, and a leading position in a growing industry. Many believe that companies exhibiting these characteristics have better stock performance over time, and they are generally correct. That said, “quality” historically delivers its best performance during downturns (when poorly financed companies with declining cash flows tend to decline much, much more).  While no investment manager ever says that they focus on low-quality companies, the fact is that those companies tend to perform better when speculative fever is high. Some of the biggest winners this year are either highly leveraged or very vulnerable to disruption.  This has been especially true since June:

The S&P 500 is the orange (middle) line.  If you extract just the riskiest companies (blue line) from that index, you earn a much better return.  If you factor out the highest quality companies, you would be under-performing

5.       Profit Taking Sounds Good, Realization of Taxable Gains Does Not

One of the things that made the bursting of the dot com bubble from 2000-02 so painful was that investors saw their tech portfolios lose 60-85% of their value, AND they had to pay capital gains taxes!  Understandably, investors prefer to avoid taxes, so they are disinclined to sell positions that have appreciated significantly in value. What tends to happen, therefore, is that when stock prices begin to fall, investors tend to sell those positions with just modest gains and hold the ones with larger gains. This is called “profit taking”, and it is quite common. However, every decade or two, there is a significant sell-off where investors start to panic and sell more indiscriminately. The big winners tend to become big losers because those stocks and funds that didn’t see much profit-taking in the up years begin to “catch up” on the downside.  These stocks have a significantly greater amount of embedded capital gains, so even down 50% or more the tax hit can be very large.

Again, all of this is offered not because I expect the tech sector to go down substantially very soon, but because I know some sort of re-adjustment is almost sure to happen and it might happen soon.  We hear a lot about AI these days, but one should understand that large future sales of power, data centers, and semiconductor chips are already priced into most stocks. The kinds of things that I look for to tell me that risks are elevated – high valuations, narrowing market breadth, decreasing free cash flow, low quality leadership – are considerably more prevalent in the technology sector now than they were three months ago, which increases my nervousness.  With liquidity conditions positive and interest rates set to be cut twice more this year, I think the odds of something major happing in 2025 aren’t high.  I am, however, looking harder than I have in years at finding areas outside of the AI trade to shift assets to.

[1]Additionally, the new budget law recently enacted by Congress (OBBBA) allows a much slower depreciation schedule (6 years instead of 3.  This change has given these firms a reported earnings benefit of 7-12% in 2025, according to TenViz.  Since the actual chip and server technologies are becoming obsolete faster rather than slower, arguably depreciation schedules should have shortened rather than lengthened.

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