Equity markets continued their multi-year march higher in the third quarter, with the S&P 500 finishing in positive territory for the seventh time in the past eight quarters (and ten of the past twelve). Market performance was driven by a mix of factors, but perhaps none more so than continued enthusiasm for artificial intelligence (AI) and infrastructure related to its buildout. Stocks levered to AI outperformed again in the third quarter, and many traded at lofty valuations, a demonstration of the attractiveness of the market opportunity AI presents. However, both AI and a richly valued market are not without risks, and we continue to monitor both.
U.S. stocks, as measured by the S&P 500 Index, rose 8% during the third quarter, including dividends. International stocks, as measured by the MSCI All Country World Index ex-US, rose 7% in the quarter, including dividends. The continued rebound in international stocks is notable after years of underperformance and has been driven in part by compelling relative valuations, expansionary fiscal measures taken by large Western economies, and the depreciation of the U.S. dollar, which brings a positive foreign exchange benefit when translating foreign stock prices to $USD.
From a valuation perspective, the S&P 500 Index currently trades at 22x forward earnings estimates, which remains well over one standard deviation above the 30-year average. International stocks, by contrast, trade at just 16x forward earnings – still near multi-decade lows despite their substantial run this year.
Stocks follow earnings
A frequent question we hear from our clients is, “How can the stock market be trading at all-time highs given all the economic and political uncertainty”?
It is a natural question given how well the market has performed over the past few years, and one we think a lot about ourselves. And while there’s never one reason, the simplest answer makes the most sense to us: stocks follow earnings. Over the past four years, the S&P 500 has climbed 53%, while earnings expectations for the S&P 500 have risen 34% over the same period. Although valuations are well above long-term averages and expensive relative to historic norms, it’s hard not to argue that strong earnings have contributed meaningfully to recent market performance.
Underlying earnings were again a major driver in the third quarter, particularly in technology, as semiconductor and cloud infrastructure companies solidified their recent market leadership. Expectations for accelerating AI adoption and related capital expenditures drove the entire AI ecosystem (semiconductors, data center operators, cloud platforms) higher.
While the technology and communication services sectors have clearly been propelling the market higher, it’s important to note that market breadth has been strong, with ten of the eleven S&P 500 sectors now higher for the year. The only sector in negative territory at the close of the third quarter was healthcare, furthering a multi-year trend of underperformance.
Outlook
After three years of outstanding U.S. equity market performance, we now view the outlook as more balanced, with continued strong earnings reports squaring off with a few early signs of a slowing U.S. economy.
Earnings reports year-to-date have been strong, and momentum continued to build in the quarter. For those companies providing Q3 guidance, 22% were ahead of analyst estimates (the highest reading in a year), while the percentage of companies lowering guidance was the smallest in the last four quarters. Plus, a series of recent tech company announcements suggest the outlook for corporate earnings remains strong.
The U.S. economic outlook appears somewhat softer, with lower revised new jobs figures in recent months and inflation remaining persistently above the Fed’s 2% target. These recent economic data did not preclude the Fed from lowering the federal funds rate by 25 basis points in September, as Fed governors believed the softening labor market warranted what Chairman Powell described as a “risk management cut.” Committee members are forecasting two more rate cuts in 2025, and markets agree, though persistently high inflation suggests the path to additional rate cuts is not set in stone.
Tariff policy similarly remains a wildcard; however, the market at this point is concluding the worst of the tariff surprises have passed. That said, tariff announcements from the administration keep coming, notably those indicating a 50% tariff on select housing products and a 100% tariff on branded pharmaceuticals. Companies have, for the most part, moved quickly to raise prices, cut costs, and adapt their supply chains in reaction to the new higher tariff environment, though the long-term impact on the U.S. consumer remains a trend worth watching.
Despite some headwinds, we remain positive on the outlook for both equity markets and the underlying fundamentals that drive them. That said, the pairing of potential headwinds with historically high valuations does increase the likelihood of market volatility in future quarters.
At Howland Capital, we believe our buy-and-hold approach to investing supports long-term investing through market cycles. That said, we recognize that our clients’ unique life circumstances don’t always allow for longer-term thinking. That is why communication is such an important component of our relationships with our clients. If you believe your financial needs or aspirations are changing, we encourage you to reach out. This allows us to make thoughtful adjustments with you and respond to opportunities in a way that works best for you. We are here to help you plan ahead, no matter what life brings.
