Market Recap
U.S. equity markets finished the fourth quarter on solid footing, with the domestic stocks rising 2.7% and ending the year up 17.9%. Gains continued to be driven by strong corporate earnings, particularly within a concentrated few technology and artificial intelligence large-cap, growth-oriented companies. Large-cap growth stocks outpaced value (18.6% vs. 15.9% for the year), while small caps posted more modest gains, ending 2025 up 12.8%. International equities meaningfully outperformed U.S. markets for the first time in several years, gaining 4.9% in the quarter and delivered a strong 31.2% return for the year. A weaker U.S. dollar, down 9.4% in 2025, provided a notable tailwind for foreign assets. In fixed income markets, the Federal Reserve cut rates by 25 basis points in December, bringing the policy rate to 3.5%–3.75%. Bond returns were positive, up 1.1% in the quarter and finishing the year with their best performance since 2020.
Investment Outlook & Portfolio Positioning
At the start of 2025, investor expectations were relatively modest, with many forecasters projecting U.S. equity returns roughly in line with earnings growth of about 8%. As the year unfolded, markets significantly exceeded those expectations, more than doubling initial forecasts. While market predictions are often wide of the mark and should be taken with a grain of salt, each year-end brings a new round of outlooks. As 2026 approaches, consensus equity return estimates once again cluster around 8%, though forecasts span a wide range. Most strategists expect domestic stock returns to fall in the mid-single to low-double digits, driven by continued earnings growth in the low-double-digit range and modest valuation compression that tempers overall returns.
Equity valuations remain elevated to start the new year trading near 23x forward earnings, well above their long-term average of roughly 15.6x. This reflects investors’ willingness to pay a premium for expected growth, supported by optimism around economic resilience and another year of solid earnings. Elevated valuations do not imply an imminent market downturn, but they do tend to constrain longer-term returns. Historically, periods with similar starting valuations have been followed by lower subsequent real returns over the next decade, though the historical sample is limited. In the shorter term, high valuations may increase market sensitivity to earnings disappointments or shifts in investor sentiment.
Looking ahead, current valuation levels suggest returns will be driven more by earnings durability and cash-flow generation than by further multiple expansion. Notably, much of today’s technology-led earnings growth is underpinned by tangible, long-term capital investment rather than financial leverage, differentiating this cycle from prior valuation peaks. Elevated spending across artificial intelligence, energy, and infrastructure reflects responses to demographic pressures and labor scarcity. While cyclical risks remain, these multi-year investment trends may help support growth and reduce the likelihood of a traditional recession. In this environment, elevated valuations reinforce the importance of selectivity, diversification, and a focus on companies with durable earnings power and strong balance sheets.
As we’ve highlighted in past commentaries, the U.S. dollar is a key factor in foreign equity outperformance. The ICE U.S. Dollar index fell nearly 10% in 2025—providing a nice kicker on top of already strong foreign equity returns. The strength of the euro and British pound relative to the U.S. dollar was the culprit behind the dollar’s depreciation. MSCI Europe returned 20.6% in local currency terms—a figure modestly better than U.S. large caps—however, the decline of the dollar boosted MSCI Europe’s return to 35.4% in dollar terms. Valuations for international stocks remain attractive and are currently trading at a meaningful discount compared to U.S. stocks. Even after a strong 2025, we see value in select international exposures given attractive valuations and the non-dollar currency exposure they provide – particularly if the U.S. dollar continues to weaken alongside Fed policy shifts and our continued high and growing level of government debt.
The Fed and monetary policy remain a key focus. The Federal Reserve cut rates three times during the year, and the FOMC’s current expectation is for one more cut in 2026. Given the strength of year-end economic data and stubborn inflation, we don’t believe we will see rapid or aggressive rate cutting in 2026, at least not in the early part of the year. Markets are predicting and pricing in two and a quarter rate cuts next year, which would bring the Fed funds rate to approximately 3%. The FOMC’s single-cut expectations reflect caution about above-target (2%) inflation while acknowledging a softening job market. A modest rate-cutting environment can be supportive for both stocks and bonds, but a return to the 0% interest rates that fueled strong stock price appreciation earlier in the decade is unlikely. With Fed Chair Jerome Powell’s term coming to an end in May 2026, there is growing concern that the Federal Reserve will become more politicized. Some investors worry that political influence at the Fed, specifically pressure to meaningfully lower short-term interest rates, will lead to higher inflation, higher long-term interest rates, and more volatility in the bond market.
As for current bond yields, higher yields have improved the income potential of bonds compared to recent years. 10-year Treasury yields finished the year in the low-4% range, offering decent levels of income while also providing diversification benefits within portfolios. Investment-grade corporate bonds continue to reflect strong credit quality, but credit spreads are relatively tight, limiting price appreciation in corporate credit. High-yield bonds also have compressed spreads, signaling investor confidence in the economic outlook and corporate balance sheets, but leaving less room for error should growth slow meaningfully or defaults rise. These high valuations in the bond market, like the equity market, argue for selectivity. Our base case is that the yield curve will steepen in 2026. We think most of the steepening will come from the front-end moving lower. As of year-end, the Fed Funds rate range is 3.5%-3.75%. In contrast, we think longer-term yields are likely to stay relatively stable. This is due to the never ending growth in budget deficits that lead to an increasing supply of government borrowing and bond supply. The positive of all this is that we continue to see attractive yield opportunities in the 5%-6.5% range across credit and securitized markets, allowing us to capture attractive income without overreaching for return in our balanced portfolios.
Alternative or non-traditional investments continue to offer risk-reduction benefits, while providing solid return potential. Managed futures historically have performed well in high volatility environments, which could easily resurface again as the year unfolds. Commercial real estate appears to be bottoming and providing some interesting upside in selective sectors (i.e. – distribution/logistics, industrial, specialty sciences, etc.), given lower supply and higher demand. Diversification and low-correlation characteristics are additional benefits, as well.
Closing Thoughts
Looking ahead to 2026, our outlook remains cautiously optimistic, as we expect modest, but slowing, economic growth. Support for this comes from consumer spending and an ongoing investment cycle tied to infrastructure, energy, and productivity-enhancing technologies. While AI-related investment has been a major contributor to recent growth, we expect its pace to slow from the exceptionally fast levels seen over the past two years. Importantly, the macro backdrop appears neither strong enough to force monetary tightening nor weak enough to meaningfully undermine corporate earnings.
This cycle has challenged many traditional economic and market frameworks. Signals that have historically predicted recessions such as an inverted yield curve, weak leading economic indicators, and rising unemployment have so far failed to produce the expected recession. While these indicators should not be ignored, relying on them in isolation may prove less useless in an environment shaped by demographic constraints, constrained labor supply, and sustained capital investment. In such a regime, flexibility, diversification, and a focus on underlying fundamentals remain more valuable than adhering to historical rules of thumb.
We thank you for your continued trust and partnership and wish you a blessed 2026! Please also find enclosed the economic newsletter from Dr. Ray Perryman.
The Water Valley Investment Team