The Markets
The stock market rally continued in the third quarter, delivering the strongest Q3 gains since the post-pandemic rebound in 2020. Despite ongoing uncertainties surrounding tariffs, employment, inflation, and geopolitical risks, markets advanced in relatively calm fashion. Volatility remained unusually low, with the S&P 500 avoiding a pullback of more than 3% for the past five months.
Investors appear less reactive to daily headlines from Washington, while becoming more confident in the resilience of both the economy and the markets. This shift was supported by strong second-quarter earnings results, with most companies beating expectations and analysts revising estimates higher. As Q3 earnings season begins, markets will focus on whether forward guidance aligns with expectations for the remainder of 2025 and into 2026.
The S&P 500 gained 8.1% in the quarter, bringing its year-to-date return to 14.8%. Gains were broad-based, with only the Consumer Staples sector losing ground. Growth strategies – particularly the largest companies – led again, while small caps staged a rebound and value strategies added to strong first-half gains. The quarter also saw signs of increased speculative activity, including a surge in IPOs, strong performance in unprofitable companies tied to AI, bitcoin, and quantum computing, and a notable rally in gold.
A major driver of both economic and market strength has been unprecedented capital spending on AI infrastructure. Hyperscalers such as Amazon, Meta, Microsoft, and Google are expected to push AI-related investments toward $500 billion by 2027. Scale is seen as the critical differentiator, with “bigger and more powerful” capacity expected to secure a long-term advantage.
Skepticism over whether these firms can generate adequate returns on such massive outlays has, for now, given way to enthusiasm. OpenAI, the developer of ChatGPT, has partnered with Oracle, Broadcom, Nvidia, and others to secure chips and cloud capacity – lifting the stock prices of those partners. They have also invested in their customers, creating a spending loop that raises questions of interdependence. Though still private, OpenAI’s implied valuation would make it one of the most valuable companies on any public exchange.
Fixed income markets were quiet. Yields eased across the curve, with the short-end reflecting expectations of two more Fed rate cuts this year. The long end, which influences borrowing costs, including mortgages, also declined, with the 10-year yield ending the quarter near 4.15%.
Investment Strategies
Growth Equity Strategy:
The Meritage Growth Equity strategy performed particularly well in the quarter, outpacing its growth benchmark for both the period and year-to-date. Technology and Communication Services were the strongest sectors, while Energy and Health Care lagged. Key contributors included overweight positions in Alphabet (court decision did not require breakup), Broadcom (big jump in orders for custom chips), KLA Corp (broad semiconductor rally), and two Chinese holdings, Alibaba and Baidu (overlooked AI beneficiaries). Apple, rebounded from a 20% decline, and Nvidia returned to all-time highs.
Value Equity Strategy:
The Meritage Value strategy outperformed the value benchmark in the quarter, continuing strong relative performance for the year. Consumer Discretionary and Health Care were the strongest sectors for the strategy, led by Tapestry (Coach bags), Halozyme (biotech research), and eBay (sales model enhanced by AI). Relative weakness came from Materials, Communications, and Consumer Staples, where quality holdings Costco, Philip Morris, and Kroger declined.
Yield-Focus Equity Strategy:
The Meritage Yield-Focus strategy had an excellent quarter, building on the strong results of the first half. Gains were spread across Industrials, Consumer Discretionary, Technology, Utilities, and Real Estate sectors. Price appreciation reduced the portfolio dividend yield to 4.5%, still more than three times the S&P 500 yield. The strategy maintained a 35% allocation to non-U.S. holdings. Several outstanding performers in the Tech sector came from non-Mag 7 names like Corning, HP Enterprise, and Open Text.
Small-Cap Equity Strategy:
The Small Cap Core strategy participated in the Q3 rebound after a sluggish start to the year. Growth-oriented companies led the advance. Continued strength in this space, supported by additional rate cuts, would signal a healthier broadening of the market.
Fixed Income Strategies:
Meritage bond portfolios delivered positive returns, in-line with benchmarks. Yields ended the quarter modestly lower, reflecting softer labor data and anticipated rate cuts. For now, bond investors are not pricing in sustained inflationary pressures, though tariffs may cause a one-time bump in prices. If inflation picks up from current levels, longer yields would likely move higher, potentially unsettling the equity market. The short/intermediate duration positioning of our bond portfolios should provide some protection in that scenario.
Additional fixed income commentary is available at the link below. https://www.meritageportfolio.com/fixed-income-investment-update-q3-2025/
Other Thoughts
Valuation
A recent Ned Davis Research report highlighted that U.S. equities look expensive by nearly all measures. Since late 2022, stock prices are up 80%, while earnings have risen just 16%, leading to multiple expansion. The forward P/E ratio is now approaching levels last seen during the dot-com bubble and the post-pandemic rebound.
The purpose of the study was not to state the obvious, but to make a more informative comparison of valuation to historical averages. After adjusting for the economy’s transition from industrial/goods to technology/services, higher structural profit margins, and shifting index composition (bigger Tech/Communications weight), the report concludes:
- Valuations are elevated (not just the Mag 7) but not at bubble extremes.
- Current multiples are supportable assuming expectations of above-average earnings growth are met – meaning much of this is already priced in.
- Valuation is best viewed as a measure of risk, not a timing tool.
There are often other catalysts that trigger corrections than valuation alone – such as a recession. As we’ve seen many times, market valuations can remain extended far longer than a market timer’s patience.
Concentration Risk
The top 10 companies now account for roughly 40% of the S&P 500’s value, giving a handful of holdings a disproportionate impact on performance. This raises concern that the diversification benefits of a basket of stocks or single portfolio are reduced. As attractive as today’s mega-cap tech stocks are, they are intractably tied to the AI narrative. Seeing broad market indices perform like a Tech Fund in a bull market has been rewarding, but may prove less so when conditions change.
That said, today’s mega-caps are fundamentally stronger than past leaders in high-concentration eras. They generate massive free cash flow, operate globally, and span multiple industries—hardware, software, cloud, security, search, streaming, retail, and more. Their scope extends beyond a tech sector play – they are increasingly viewed as infrastructure for the global economy. The greater risk may not be a sector issue, but whether emerging tech challengers eventually encroach upon current leadership.
Looking Ahead
As we noted last quarter, stock prices were pricing in stronger second-half earnings – and so far, that thesis has held. Barring an external shock, corporate earnings expectations for late 2025 appear achievable.
Economic data remains mixed. The latest GDP growth estimate was revised up to 3.8%, yet leading indicators, sentiment surveys, manufacturing activity, and job growth have all weakened. Linking stock performance directly to the economy is always imprecise, especially when economic trends are murky. Without trying to overthink all this, we believe we still have a constructive backdrop in place with more Fed easing in front of us. If rate cuts go too far, too fast, we know how quickly sentiment can turn. Our efforts are best focused on individual company fundamentals as the most reliable guide to long-term growth.
We continue to evaluate portfolio asset mixes relative to policy targets, aiming to avoid entering a downturn with above-average risk exposure. This is more complex for taxable accounts, depending on the capital gain circumstances. Given the strong run we’ve seen in equities, we’d lean a little more toward asset-mix discipline at this time. Please let us know if you’d like to discuss this further.
