News & Insights

We warned about froth in equities last month, and the S&P 500 responded with a sharp correction. The index experienced a steady slide from its peak of 6,163 on February 19th, closing in correction territory down 10.3%, on March 13th. The more volatile NASDAQ 100 slid 13.5% during the same period. A subsequent bounce left both indexes trading in territory they originally reached six to nine months ago. After starting the year up about 4%, 2025’s market now has a foot in the hole.

It is no surprise that the biggest contributors to the market’s multi-year gains, the so-called Magnificent 7, also paced it on the way down. The March 17 cover of Barron’s Magazine illustrated their pullbacks from respective 52-week highs. Six of seven showed declines in a range of 19%-23%. Tesla showed a 50% decline, returning to its pre-election range. The graphic was printed on a solid red background under the heading “Mag 7 on Sale”. Barrons Cover Curse believers might debate whether the red background portends a green bounce or whether the reference to stocks “on sale” foreshadows another leg down. Either is certainly possible. The S&P 500’s trailing P/E ratio remains in the mid-20s, at the high end of its all-time range. A return to the 20-year average of about 16 would equate to nearly a 40% drawdown from here, give or take earnings growth for the constituent companies. On the other hand, while corrections are historically common and occur about once every two years, bear market drawdowns of 20% or more occur only half as frequently. Treating every correction as a budding bear market is equally likely to be right or wrong.

After two great years in the equity market, 2025 got off to another strong start with the S&P 500 making record highs driven by earnings growth and non-Magnificent 7 stocks. Valuations are stretched, and there are other signs of froth in the market, arguing for caution. The economy is on solid footing with moderate employment gains and continued economic growth. However, inflation remains higher than the Federal Reserve’s 2% target and the Fed anticipates only a half percentage-point reduction in the Federal Funds rate this year. Long-term rates remain about where we entered the year. Their direction from here will be a function of inflation and government borrowing requirements as the new administration implements its tariff and fiscal policies.

Year to date the S&P 500 is up 4.2%. But in a change, the Magnificent 7, about a third of the index, has lagged while the other 493 stocks have powered the gain. Excitement for Artificial Intelligence continues to drive the market and its impact was visibly seen on January 27th when DeepSeek, a Chinese AI firm, reported using older Nvidia chips to train AI models at a fraction of the cost of current methods. Nvidia, the leading AI chipmaker and stock powering the AI revolution, dropped 17% on the news. Since the announcement Nvidia has recovered most of this drop as investors were soothed by the increasing capital expenditure plans from other Magnificent 7 members Microsoft, Alphabet, Amazon, and Meta Platforms. However, except for Meta these “Cloud Titans” have seen their shares struggle as investors stomach these massive spending plans while worrying that revenue from AI won’t fully justify them.

Market volatility has picked up in early 2025, a continuation of December’s fluctuations. This shouldn’t come as a surprise as several factors are each promoting increased volatility. The greatest impact results from investor concern over interest rates. The Federal Reserve controls short-term interest rates by setting the Fed Funds rate, the interest banks charge each other when lending or borrowing excess reserves. The Fed has cut this rate three times since September 18, kicking off its easing cycle with an eye-catching 50 basis point reduction prompted by a weak employment market in the late summer and early fall. The market, however, determines interest rates for everything else. While the Fed Funds rate is down a cumulative 100 basis points since the September Fed meeting, yields on the 10-year Treasury Note have risen 80 basis points during that time from 4.00% to a recent high of 4.80%.

Despite the drag from 11 rate hikes from March 2022 to July 2023, the U.S. economy has continued to grow solidly overall with a few pockets of weakness emerging, particularly in manufacturing. Employment growth has remained positive with modest job growth from April through October giving way to stronger numbers in November and December.

The Year In Review: A Reflection on Markets and the Economy

Equity investors have much to celebrate this year as indices continue to rise to all-time highs. The Federal Reserve cut interest rates in September for the first time since 2020, boosting investor optimism and supporting the strong rally in stock prices. In a reversal of recent trends, small-cap companies represented by the Russell 2000 index surged post-election, outperforming large-cap companies. Optimism for policies favorable to U.S. companies may have contributed to some of the outperformance as smaller companies tend to have more exposure to domestic markets.

Stocks were already trading near all-time highs prior to the election, after which markets took another leg higher. Overall, equities have been supported this year as the economy has held up better than many expected following the Federal Reserve’s interest rate increases to combat inflation. A combination of inflation tracking back towards the Fed’s 2% target and concerns about a softer labor market set the table for the Fed to kick off an easing cycle in September with a larger 0.5% cut, its first rate reduction in four years. Beginning the path toward less restrictive policy while consensus expectations reflect projected earnings growth of nearly 10% in 2024 and approximately 15% in 2025 make a relatively attractive backdrop for equities, helping to explain some of the bullish sentiment exhibited by investors.

The Fed continued down the path toward easier policy with a 0.25% cut in November with expectations for another 0.25% reduction in December. Market expectations are for an additional 0.50% of easing in 2025, which should help support equities. Additional rate cuts meaningfully beyond that over the coming year would likely be in response to unwelcome economic or geopolitical developments.

Judging solely by the U.S. stock market, economic conditions could hardly be any better. Year to date, the S&P 500 is up more than 22%. Investors may be taking their cues from economic data suggesting a desirable “Goldilocks economy,” one that is neither too cold nor too hot. Economists forecast U.S. Gross Domestic Product to be up about 2.5% for 2024. Inflation has been gradually ebbing.

Underlying statistics paint a murkier picture. Manufacturing has been in a recession for most of the past two years, and new factory orders continued to decline in August. The Institute for Supply Management’s Purchasing Managers Index showed continued contraction into September. The weakness is largely due to high interest rates that reduce demand for big-ticket consumer and industrial goods like cars, appliances, and factory machinery. The Federal Reserve’s goal in hiking interest rates in recent years was to slow down the economy by making large items more expensive to finance. Demand for services, about 80 percent of the economy, continues to rise steadily.

While the S&P 500 remains near all-time highs, markets have been choppy as sentiment has vacillated between belief in the Federal Reserve’s ability to achieve a soft landing versus concerns regarding a more significant slowdown. Progress on inflation set the table for the Fed’s half-point rate cut at its September meeting, as Chair Powell had noted that the balance of risks to the Fed’s two mandates, price stability and stable employment, have changed. Inflation has come down, trending toward the Fed’s 2% target, while the labor market has slowed. Given the increase in downside risks to employment, at the Jackson Hole gathering Powell stated the Fed “does not seek or welcome further cooling in labor market conditions,” clearly articulating the Fed has shifted its focus, opening the door to a rate cutting cycle.

The September rate cut was the first reduction since 2020, marking the end of the policy tightening the Fed embarked upon beginning in March 2022 to combat inflation. Rate hikes resulted in the target range for the federal-funds rate hitting 5.25%-5.5%, a two-decade high, and remaining there for 14 months prior to the recent cut. This hiking cycle had the desired impact as the Fed’s preferred measure of inflation, the core personal-consumption expenditures index (PCE) came down to 2.6% in July, the most recently available data, compared with a peak of more than 5.5% in 2022. Based on consumer and producer price data already released for August, economists expect the headline PCE for August will be approximately 2.3% with the Fed’s own preferred inflation measure, the core PCE, advancing 2.7%. While we are not yet at 2% inflation, the general trend has been in line with what the Fed would like to see, and policy remains restrictive, albeit less so than before the recent cut.

For much of 2023 and into 2024, markets experienced a low level of volatility in the face of the fastest interest rate tightening cycle in U.S. history. However, since reaching a peak on July 16 the S&P 500 recorded both its best and worst days since 2022 during the week of August 5-9. The reasons for higher volatility are a softer economy, Artificial Intelligence (AI) skepticism, global uncertainty, and a contentious election cycle.

Since 2022, the Federal Reserve has been able to focus on inflation as the employment market has enjoyed a strong recovery from the pandemic. The news here recently has been good. After inflation slightly increased during the first quarter, the CPI has now slowed for four straight months. July’s reading of 2.9% year over year marks the first time since March 2021 that the index has been below 3%. Progress on the core CPI, a measure that excludes the often-volatile food and energy components, is also encouraging, coming in at 3.2%. Other indicators confirm inflation’s downward path. The Fed’s preferred inflation index—the Personal Consumption Expendi­tures, or PCE—has fallen from a high of 7.1% two years ago to 2.5% in June. The Producer Price Increase, or PPI, rose 2.2% year over year in July and has cycled around 2% since early 2023.

After spending much of the year lagging behind the Magnificent 7, a broader array of stocks joined the party and pushed the market to all-time highs. The reason appears to be investors’ growing belief that the Fed will start cutting interest rates in September in response to falling inflation and a softer employment market. Interest rate cuts would improve the prospects of non-technology stocks by spurring economic activity and increasing the appeal of those paying dividends. 

Investors take cues from the Fed’s data dependency when setting interest rates to fulfill its dual mandate:  full employment and stable prices. The Fed started the year expecting three rate cuts in 2024, but inflation’s rise and a solid employment market in the first quarter led the Fed in early June to revise its expectations to just a single quarter-point cut. 

Economic growth has been steady, unemployment is relatively low, and the stock market is flirting with all-time highs. Yet, 68% of Americans rated economic conditions as fair or poor in a recent survey. Meanwhile, 32% said the economy was good or excellent.

The problem isn’t the overall economy, but different perspectives based on one’s position in the economy. An investor with a substantial stock portfolio considers conditions to be pretty good because their personal circumstances are likely favorable. Someone who doesn’t own stocks might not share that rosy point of view.