Third Quarter 2025: Market Update
This note is for anyone who's been told, maybe not infrequently, that they need to look on the bright side. This year has been a test for those of us that have viewed the market’s resilience with some healthy skepticism. On a net basis, stocks have moved higher in the face of aggressive tariff policy, stubborn inflation, and a job market that is showing some signs of weakening. Investment in AI and continued growth of chipmakers have powered stocks, and their valuations, to new heights. The AI juggernaut, Nvidia, has reached not just industry-leading but market-leading size, illustrating how the fate of the two are more intertwined than ever. Still, despite this concentration risk and the S&P 500 already being up 14% through the first 9 months of the year (about 70th percentile of returns through 3Q), we see a set up for the market to end the year on solid footing.
Stocks are no doubt expensive, with the S&P 500 trading at 23x forward earnings, about the 95th percentile since 2000. Even FED chair Powell made a rare direct comment on valuations, saying they are “fairly high.”
By another measure, the (Warren) Buffet Indicator currently shows that the market cap of US stocks is 2.2x the national GDP (the highest reading ever), generally meaning that we’re not making more stuff, stuff is just getting more expensive.
Continuing with the theme from our letter last quarter, tech, specifically AI names, continue to push us higher. Nvidia has gone from 6.6% of the market to start the year, to 8% now. That may not sound like a lot but consider that Nvidia and Microsoft were about the same size in December and now Nvidia is almost $800B larger than Microsoft, which is second in size. That difference is roughly the market cap of Walmart, one of the nation’s largest businesses. It’s no longer difficult to imagine this company being 10% of the stock market as it continues to snowball.
Investors are more eager than ever to cheer new AI deals, instantly rewarding Nvidia for a $100B investment in OpenAI (ChatGPT) by adding >$300B to the company’s market cap. The immediate credit for a large return on investment is noteworthy, to say nothing of concerns over the circularity of an investment like this (Nvidia investing in a customer so it can then buy more of its chips). OpenAI’s subsequent partnership announcement with AMD sent the latter’s shares up over 30% despite legitimate questions over financing and bottom-line impact.
So, things certainly feel a little toppy. But stripping out some high-flying tech stocks, the market is valued closer to 20-21x earnings, still expensive but much more reasonable, particularly in a rate-cutting environment. Historically, equities have tended to climb when growth is intact and monetary policy is easing, even when valuations are above average. Driven by AI, tech can continue to act as a buoy for stocks as a steady stream of new deals adds to momentum. In the short-term, inflows matter more than return on investment, so prudent follow-on deals signal confidence.
Returns are likely to be more muted through year-end and, while the government shutdown and potential incremental weakness in economic data pose some risks, we still see a solid set up supportive of stocks. Consumer spending (about 70% of the economy) looks resilient and the market is now fully buying into the FED’s 2 projected rate cuts through the end of the year. Strong 3Q tech earnings should also offer plenty of talking points to fuel optimism about AI investment and applications without the burden of giving 2026 guidance.
We believe that being underweight tech, while remaining fully invested, is a prudent approach that keeps us defensively positioned but not fighting the tide. We continue to build a best ideas portfolio of high-quality companies without chasing speculative returns. As Peter Lynch said, “know what you own, and know why you own it, and don’t let the market’s enthusiasm sweep you away.”
