Q2 MARKET UPDATE & ECONOMIC OUTLOOK

Note: This report is available in PDF format HERE.

EXECUTIVE SUMMARY

• Stocks were somewhat overvalued at the start of the year compared to recent historical valuations.  They sold off massively, rallied back nearly as quickly, and by the end of June have returned to where they started (somewhat overvalued).
• In the recent rally back to all-time highs, the market is pricing in “good news”.  If the tariff war returns, or tax cut extensions fail to pass, the market could still be easily spooked.
• The overall economy remains strong, but with some slowing in the underlying data.
• While U.S. GDP contracted in Q1, current projections are for a strong Q2.
• Barring unexpected inflation, the Fed is likely to cut interest rates later this year.
• Our base case for the rest of the year is for stocks to rise in proportion to EPS growth, but to expect volatility.  While we don’t forecast predictive targets (such as a year-end S&P projection), this could lead to an additional 5% to 10% index appreciation which would be justified by economic growth.  Stocks climbing above this level would continue to stretch multiples.
• Having started the year in a more aggressive manner, we have moved our portfolios to a risk-neutral position.  We anticipate remaining in this position for the next thirty days and will reevaluate risk once the tariff situation has been further clarified.

OVERVIEW OF THE RALLY

We begin with the same starting point with which we began our previous quarterly assessment:

The marketentered 2025 with elevated, pricier-than-average stock values. Keep in mind that this, in itself, is not a reason to sell. The market can continue to rally on good news and, in theory, could do so indefinitely. You never sell onlybecause things are “up”. Elevated stock prices are the equivalent of a yellow “caution” light in traffic.

When the above was written, the S&P 500 had dropped 8.7% from its peak (and 4.27%year-to-date).  Following “Liberation Day” just a few days later, an even sharper selloff initiated, with the S&P500 dropping a total of 18.9% in less than sixty days.  From there, a rally that gained momentum after several quick false starts launched. The S&P surged back to an all-time high to close the second quarter, having regained all of the lost value in less than ninety days.

In the first quarter of 2025, with the stock market dropping, the S&P 500 was massively outperformed by gold, international investments, bonds, and other “safe havens”.  In the second quarter, the opposite was true, with the major U.S. market indices outperforming.

Combining the twoquarters, the year-to-date performance of the S&P, Dow Jones IndustrialAverage, Nasdaq, and Russell 2000 still trail the strong performance of bothgold, international stocks, and even some bond indexes.

Again, after whatfeels like an unbelievable rally, stock averages have just rebounded to where they were a few months ago.

TARIFF OVERHANG

At the end of the second quarter of 2025, there remains significant confusion regarding tariff policy.

On April 2^nd, 2025, President Donald Trump announced a series of massive tariffs on what he termed “Liberation Day”.  The markets reacted highly negatively.  Seven days later, the day before they were to go into effect, he announced a “pause” on those tariffs.  This coincided with the initiation of the historic market rally.

That pause is set to expire on July 9^th.  Tariffs, in short, may be about to reemerge as front-page news.  

While the administration has claimed to be negotiating up to seventy-five trade deals at once, very little has been made publicly known. Treasury Secretary Scott Bessent has teased an extension of the pause as far as Labor Day, while the President has suggested that at least some tariffs will go into effect on July 9^th.  After cancelling negotiations with Canada, he also announced recently that he will “invent” trade deals for countries that refuse to negotiate.

The stock market, with its rallyback to the top, seems to believe that the administration will either announceanother “pause” for additional tariff negotiations, or will enforce tariffs,but at much lower rates than the ones announced on Liberation Day (noting thatlower tariffs may have always been the goal and the higher rates were anegotiating tactic).

A third possibility requires further expansion, which is that the market is expecting the courts to unwind most of the “deals”, even if they are briefly put in place.  

President Trump signed an executive order on 02/01/2025 giving the executive branch authority to impose these tariffs.  The order declared a “national emergency” and referenced issues such as fentanyl trafficking and the national trade deficit.

In doing so, andwith the steps taken so far, there remain many unclear legal issues:

• Can the baseline tariff of 10% remain in place at whatever point the “emergency” is ended?
• Even in an emergency, can the President supersede duly ratified trade deals?  The United States, for example, has a free trade agreement in place with South Korea, ratified by Congress, and signed by President Donald J. Trump on 09/24/2018.  
• In the end, is Congress expected to ratify the new deals, or does the administration expect that they will permanently be in effect, in place of previous trade deals, through strictly Executive Action?

On 07/31/2025, the U.S. Court of Appeals for the Federal Circuit will begin hearing oral arguments regarding just these issues.  It is likely that the case will ultimately end up at the Supreme Court.  One interpretation of the recent, broad-based stock rebound is that the market thinks the tariffs may not be allowed to remain in effect long-term.

We take so much time to lay this out as it is one of the biggest unknowns, adding confusion to the economy.  In fact, without the tariff issue overhanging the economy, the Fed may have already moved into cutting the Federal Funds rate as the President has advocated.

INFLATION & THE FED FUNDS RATE

Outside of stock valuation fundamentals, one of the factors that has the most to do with equity valuations are the prevailing interest rates.

The underlying principle is simple.  When interest rates are high, so are bond yields or the rates that banks pay on savings accounts or certificates of deposit.  These higher rates compete with stocks, which tend to carry lower valuations in that environment.  When rates are cut, bonds and CDs are no longer competition for stocks, and stocks tend to run to higher valuations: they become “the only game in town”.

Rates are dictated by the Federal Funds Rate as set by the Federal Reserve Board.  In 2022, after a period of keeping rates at zero after Covid, the Fed began to hike rates dramatically in response to surging inflation.  Near the end of 2023, the rate peaked at 5.33%, the highest level since the year 2000.  The Fed then undertook several rate cuts in 2024, reducing by one full point to 4.33%.

The expectation which we gave clients last year, which still applies, was that the Fed would enact several rate cuts in 2024 with the hope of then pausing and giving itself as long of a runway as possible before either resuming or raising rates again.

Those cuts, and future adjustments, will be based on inflation being “tamped down” as part of the Fed’s governing mandate to provide for “stable prices”.  The Fed’s stated target is to maintain stable inflation at a rate of around 2%.

The Fed seems likely to resume rate cuts soon.  In making its decisions, they primarily focus on the inflation rate of the Personal Consumption Expenditures (PCE) index, which has been testing the 2% target.  See the table below.  Note that it need not have arrived fully at that level for the Fed to begin its next move as long as they think that the trajectory is solid.

While we differ greatly sometimes, we happen to be in line with current market expectations of future Fed rate moves.  CME Group’s FedWatch predictor tool forecasts only a 20% chance of a cut in July but a greater than 90% chance of a cut in September.  The Fed’s own projections (from June of 2025) forecast two quarter-point cuts by the end of 2025.

Why is this all important?  Because, again, it has a lot to do with how stocks are valued.  More directly, rate cuts affect the profitability of businesses and help to stimulate the economy (by increasing lending).  The Federal Funds rate helps to create the environment in which stocks are priced.

There is some irony in the fact that President Trump has called for immediate cuts of 2 basis points (taking the rate from 4.33% to 2.33%), while the Fed itself would likely be closer to cutting rates if it weren’t for remaining tariff uncertainty (the specific concern is that tariffs may be inflationary, at least in the short-term).

KEY ECONOMIC DATA

Current economic data for the United States paints a mixed-to-positive picture. We interpret the current economic environment as being in a bull market for stocks.  Because that market overlays an economy which is strong but may be slowing, the bull market could exhaust without stimulus (such as tax cuts or rate cuts).

One of our preferred forward-looking indicators is the GDPNow Forecast, revised regularly by the Federal Reserve Bank of Atlanta. The indicator has a history of relatively accurate forecasts, including correctly predicting an economic contraction in Q1 of 2025.  Their current projection for the 2^nd quarter is growth of 2.5%.  This compares to last year’s year-over-year increase of 2.8% (Q2 2024) and indicates a steady, if slightly slowing, economy.

Reviewing other forward-looking indicators, the two-year and ten-year yields are no longer inverted, and haven’t been for much of the last year, after spending roughly two years (July of 2022 to August of 2024) in an inverted pattern that typically predicts a recession.  This was the longest inversion in history, one of the few that didn’t actually lead to a recession and was likely triggered by steep and sudden interest rate hikes which failed to slow the strong economy.

Another leading economic indicator, the S&P Global Manufacturing PMI reading held steady at 52.0 in June.  A number above 50 signals economic expansion.  However, the Philadelphia Fed Manufacturing Business Outlook Survey indicated weakness in June.

Finally, unemployment rates continue to require monitoring.  We primarily focus on the less-covered “U-6” unemployment number as it includes those “employed part-time for economic reasons”.  The reading has been steadily inching higher since hitting an all-time low of 6.7% in the post-Covid employment stabilization of 2022.  Since then, it steadily increased to reach 7.8% in July of 2024.  However, since then it has stabilized and sits at 7.8% today.  Similarly, job openings have stabilized, peaking at over 12 million in 2022, declining to 7.5 million in July of 2024, and reading 7.7 million today.

STOCK EARNINGS: RECENT AND PROJECTED.

In the long term, stocks move up and down based on their corporate earnings. This refers to both gross revenue projections and earnings-per-share numbers (essentially, remaining earnings after expenses).

More directly, the value of a stock today has a lot to do with expectations of earnings before they are announced, or even what analysts think the stock will be worth a year or more into the future.

Stocks tend to overperform estimates during bull markets, as they have for the last five years.  Businesses overperform expectations because analysts rely on historical data and conservative assumptions which fail to capture the market momentum until the top of the bull market.  An indicator of a market peak comes when companies overperform, but by shrinking margins.

Stocks recently completed the first quarter earnings announcements for 2025, and the results were mixed.

During Q1, 59% of companies overperformed gross revenue estimates, which are less than the average for the last five or ten years. The margin of overperformance was also less than recent averages.

However, on an earnings-per-share (EPS) basis, companies beat the five and ten-year averages:79% overperformed, vs. a respective 77% or 74%. The size of overperformance was near the five-year average.

Also noteworthy in the recent earnings announcements:

• According to S&P Dow Jones Indices, Q1 2025 share repurchases reached $258.7 billion, up 9.2% from Q12024’s $236.8 billion.
• Goldman Sachs projects total U.S. share buybacks will exceed $1 trillion in 2025, a 16% increase from 2024’s estimated$925 billion.
• Q1 2025 saw a 6% increase incorporate M&A deal volume and a 16% increase in PE deal volume compared toQ1 2024, but broader economic and policy challenges may limit further growth.
• During Q1 2025, 44% of earnings announcements mentioned a potential recession (compared to 3% last year).  86% of earnings announcements mentioned tariffs as a potential concern to business.

The first quarter takeaway is that revenue overperformance in earnings announcements was worse than average, while EPS (representing net income) growth remains strong.  An indicator that a bull market has peaked is that projections begin to catch up with companies.  We would be immediately less bullish given another quarter of weakening data.

Compared to initial estimates, projections of corporate earnings have already had significant reductions priced into upcoming announcements for the second quarter.  This refers to both analyst estimates and revisions to estimates provided by business.

On March 31^st, before Liberation Day, as sighted by FactSet, earnings-per-share estimates for the aggregate S&P 500 were $65.55.  By May 29^th this had declined to $62.91.  The average company is expected to earn revenue of about 4% less this quarter than they were projected to only a few months ago.

The optimistic view is that the lowered bar may make it easier for companies to overperform in Q2given the pause in tariffs (which are certainly the culprit which caused the downward revision).

CONCLUSIONARY FORECAST

There is an old joke among Investment Managers: if you aren’t sure in what direction the market is about to go (and who ever is?), have your crystal ball predict modest stock growth but with volatility.  Why?  Because that is the default mode of the market.  We mention it because this isn’t too far off of our current view.

When you iron out stock movements which have nothing to do with underlying valuations—such as when markets move down when bombs are launched against Iran, and then back up when it is over—what is left is a market that gradually moves up over time as the economy expands while remembering that it does not move up in a straight line (add volatility).

As it turns out—and not for the first time—our current economic outlook is cautiously optimistic, projecting modest stock growth but possibly with increased volatility.  Stocks should continue to move up as revenue grows, though the “animal spirts” may not be there to push valuations which are already higher-than-average past tangible earnings growth.  In fact, it would be concerning if stocks continued to rally past their current valuations without supportive data underneath it.

We believe that the American economy remains in a bull market, but that it is possible we are beginning to approach the top of it.  The economy is projected to grow, and companies continue to perform well in terms of earnings, though we have also seen some slowing both in corporate earnings and the economy more broadly.

The economy is likely to receive additional stimulus through Federal Reserve cuts rates later in the year.  Additional tax cuts will be implemented through the “Big Beautiful Bill” though we believe the stimulative impact will be limited as the majority of “tax cuts” will be an extension of those already in place.  The economy will also benefit from the administration’s emphasis on deregulation, though this can take some time to materialize.

Conversely, the tariff war has caused great confusion in the market and will continue to potentially overshadow it in the future, even if things seem tranquil today.

CHANGES IN OUR MODELS

To discuss the current positioning of our portfolios, we go back to the presidential election of last year.  At the point where Donal Trump was elected, we were very risk-heavy and enjoying a strong 2024.

In January of 2025 we became concerned with stock valuations and entered a process of beginning to slowly reduce risk in some of our portfolios. In short, over the course of several months we repositioned from being risk-heavy to being risk-neutral.  This included increasing bond positions, reducing stock positions, and reassessing the nature of the stocks which we did hold.

Emphasis in this process was in rotating out of technology, which we were bullishly overweight in.  We are now evenly weighted in tech compared to the S&P 500.  In place, we rotated into sectors which are expected to be recession resistant and/or tariff resistant (meaning the majority of profits and production are in the United States).  Sectors we increased included Utilities, Consumer Defensive, and Communications Services.  We continued roughly market-weight positions in Health Care and Finance.

During the last quarter we rotated somewhat further into international stocks, while still not maintaining a significant foreign weighting.  A simple average would say that we went from about 10% international to about 15%.

One of our more dramatic adjustments during the quarter was a reduction in small-cap holdings.  We had been inching into smaller companies during the previous year as they would be the primary beneficiaries of Fed rate reductions.  Doubly, tariffs affect smaller companies the hardest.  As rate cut expectations diminished and tariff concerns surged, we began to unwind those positions.  

In our core portfolios we also briefly expanded a few percent of our holdings into gold & precious metals, though this concept was mostly reversed once tariffs were paused.

We are currently comfortable with our “market neutral” position, taking about the same amount of risk as the S&P 500 in the context of weighting towards categories like technology.  After an active spring, we will likely not make many changes over the next thirty days unless a market decline leads to a buying opportunity.

With the major indexes up over the last six days to end the trading quarter, we’ve closed the period by selling a small amount of gains to try to rebuild a little “dry powder”.  This is primarily conducted in accounts which have broken back through their own all-time high balances and represents harvesting of 1-2% of the account value back into cash.

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