“Less Talk, More Brush.”
Freshman year at boarding school, we had a 10:30 p.m. lights out during the week. That meant we only had one hour between the end of study hall and bedtime. Typically, this hour was filled with watching television in the common room, eating pizza or engaging in some form of low-level hazing or other shenanigans. In the final minutes before the senior proctors living in our dormitory ordered us back into our tiny rooms, they would make us brush our teeth, and over the cacophony of freshmen laughing and snapping towels at each other, the seniors’ mantra could be heard: “less talk, more brush.” First low, like a prayer, but soon loud like a drill sergeant’s command. Enough was enough. They had college essays to write, girlfriends to call and their own shenanigans to commit. Playtime, for us, was over.
In a year during which macro themes such as tariffs, the Fed, and AI have dominated, we still must eventually arrive at 10:30 p.m. Talk and narratives are one thing, but eventually stocks must demonstrate earnings growth and cash flow generation. Fortunately, it appears that we are getting some growth; the question is whether it will be enough to sustain elevated prices.
A Strong Quarter
The global rally in financial markets continued during the third quarter as investors looked past high stock prices in the U.S. and some signs of a slowing economy. While international shares have still outperformed domestic shares so far this year, U.S. markets outperformed during the third quarter.
Once again, mega-cap tech turned in a strong performance, with the Russell 3000 Growth Index up 10.4% during the quarter and the NASDAQ returning 11.4%. Continued enthusiasm surrounding AI contributed to investment performance among the hyperscalers and other large-cap tech names. However, as strong as it was, tech performance was not quite as strong as what we witnessed in small-cap world, with the Russell 2000 up 12.4%. Small-cap value was particularly strong, up 12.6%.
Maybe the most favorable aspect of the quarter, which had a lot of favorable aspects, was that the rally was so broad—it was not a case of investors rotating out of one sector such as large-cap growth and into a sector such as small-cap value. Both categories did well. The breadth of strong performance was encouraging indeed.
The market received a long-awaited present from the Federal Reserve in a 25-basis-point rate cut in September. While inflation is still persistently above the Fed’s long-term of 2%, emergent weakness in the job market was evidently enough to convince the Fed to begin trimming rates. Furthermore, the Fed funds futures curve is pricing in another 50 points of cuts before the end of the year.
Falling short-term rates are good for stocks, all else equal, and they tend to be especially good for small-cap stocks, so it makes sense that small-caps performed so well during the quarter. Another factor boosting market performance is the revival of mergers and acquisitions activity, at least in terms of value. According to Reuters, M&A activity surged 40% globally during the third quarter, a huge development, and the crystallization of what had been an unrealized expectation about the current U.S. administration. On the other hand, the number of deals reported was historically low. Should animal spirits begin to fuel more M&A activity in the small-cap space, it could fuel meaningful additional performance.
All in, the third quarter of 2025 was a fantastic quarter. To find a quarter better than Q3, one would have to go all the way back to… the second quarter of 2025. That’s right, folks. After slightly negative returns during Q1 2025, global stocks have returned 18.4% YTD through the end of the quarter. What’s different is that the Q2 rally was off of lower prices and was driven by relief over near-term tariff resolution. Fear and volatility were in a free fall after an extremely nerve-wracking period in late March and early April. The more recent extension of Q2’s performance comes amid high valuations and signs of economic cooling.
The performance of the S&P 500, while not as strong as international stocks this year, has still been well-above historical levels, now having returned 87% off the October 2022 lows in the wake of the Fed’s rate hike campaign. Those gloomy days three years ago, when the index was trading below 16x forward earnings, seem long ago indeed. Those more modest valuations are long gone. Meanwhile, the Magnificent Seven returned 15.6% for the third quarter, with Tesla, Google and Apple leading the way, returning 40%, 38% and 24%, respectively.
The top ten stocks in the S&P 500 are collectively now about 45% more expensive than normal (29.9x forward earnings vs. 20.6x historical), and with market concentration at all-time highs (more than 40%!), that has driven the price of the overall index up to about 36% north of historical (22.8x vs. 17.0x).
What are we to make of an index of the 500 largest companies in the United States in which the bottom 490 represent just 60% of the total market capitalization? Can that be true? Well, to be fair to the top ten and their gaudy valuations, the top ten also account for almost 33% of the total earnings of the index. That means that substantially all of the earnings growth in the index has been coming from those names. So, it’s not like this development is completely irrational; near-term price performance tends to follow earnings growth, and these companies have substantial earnings growth. According to J.P. Morgan, in 2024, the aggregate earnings growth rate of the Magnificent Seven was 10x the rate of the rest of the S&P 500. This year, it is expected to be 3x the rate. However, what’s happening now is that Magnificent Seven earnings growth, while still greater than the rest of the pack, is decelerating (falling from 40% annual growth to about 21%), while earnings growth for the rest of the 490 stocks in the S&P is accelerating (from 4% last year to 7% this year). Next year, while Magnificent Seven earnings growth is still expected to exceed that of the rest of the index, it will be by percentage points, not multiples. The fact that the top ten stocks trade at a 50% premium to the rest of the index—and constitute 40% of the index—ought to give index investors something to think about. This is the time of year when markets tend to begin focusing on next year, and next year is looking like it sets up pretty well for the stocks outside the top ten.
We are not in the business of making broad index predictions, but if we were, it would be difficult not to be concerned about having such a concentrated bet at a time when earnings growth is converging and valuations are historically high.
We should note that just because stocks are expensive does not guarantee they will soon fall in price; stocks can stay expensive for a long time. However, they never stay expensive forever, because they will either fall in price or their earnings will rise to the point where they are no longer expensive. However, history and common sense both suggest that high prices suppress future returns. Stock prices move around for all sorts of reasons over the near-term. Quarterly earnings move stocks and affect returns, and so do interest rates, commodity price movements, geopolitical concerns and, sometimes, the weather. Longer term, valuation has a more meaningful impact on future returns, and the higher the entry point, the more difficult it is to have a favorable experience over, say, a five-year period. With a quarter-end P/E of 22.8x, the S&P 500 has its work cut out for it.
The Quest Narrative?
Another boarding school lesson was the introduction of the quest narrative, sometimes called “the hero’s journey” as a classic narrative framework. There was the call to adventure, the journey, the trials, the abyss, the transformation and the return. Markets are perpetual, so unfortunately, we never really get to the transformation, and we can only hope for the “return” part—but we definitely experience “the trials.”
Our hero, Mr. Market, is perhaps known more for his manic tendencies than his bravery or honor. However, over time, Mr. Market does fairly well for himself. He’s no Ulysses, but he’s our guy.
Accordingly, for Mr. Market to continue along his way to achieving suitable returns, he has to face trials, or challenges. He has to slay some beasts.
Both historically and today, Mr. Market’s two mortal foes are inflation and recession. (Note: it is no coincidence that the mandate of the Federal Reserve is to wield the double-edged sword of monetary policy in such a way that it both subdues inflation and maximizes employment.)
First, let’s consider the inflation beast. There has been a lot of handwringing about the prospect for higher inflation given that a.) pandemic era stimulus and supply chain issues caused the highest inflation rates seen since the early 1980s and b.) the current administration has made tariffs, which are the highest since the 1930s, the centerpiece to its trade policy.
The good news is that tariffs have not yet resulted in significant inflationary pressure. Importing companies have managed to partly offset them through effective supply chain management, shifting sales volumes overseas and “eating” them. However, it seems foolhardy to think they can effectively hide them from the consumer—and from their own P&Ls—forever. As Charlie Munger might have observed, do we think tariffs are going to cause prices to go down?
As it stands, inflation stood at 2.9% in August, warm but not hot. Were it not for fears surrounding the direction of inflation, it seems reasonable to believe that the Fed would have begun cutting short-term interest rates before last month given some of the clues that we have been receiving from the labor market.
This brings us to the second beast. Job creation appears to be slowing, with recent downward revisions suggesting the labor market may not be as robust as it looked six months ago. The unemployment rate has increased only slightly, to 4.3% in August, still close to full employment. However, reports of emergent softness were enough to cause the Fed to announce a 25-basis-point reduction in short-term rates in September. Markets, of course, usually respond well to interest rate cuts, and they did in this case too. However, if the economy softens enough to start bringing down corporate earnings forecasts, it could be a different story.
The last beast is what would happen if the Scylla and Charybdis of inflation and economic weakness had offspring—the dreaded stagflation scenario (and quite the compelling surprise beast if this quest narrative were made into a summer blockbuster). In this case, tariffs would cause an inflationary spiral while the economy was softening, perhaps even due to AI beginning to affect entry-level employment. In this case, the Fed’s monetary Excalibur could be rendered powerless, and the market would be in rare territory. While this would not be an ideal scenario for our hero, Mr. Market, the historical record suggests that this might be more of a Main Street problem than a financial market problem. According to Dimensional Fund Advisors, the market returned an average of 16.4% during the 12 years of the last 94 years in which we had advancing CPI and declining GDP. Again, we do not want this scenario, but at least there is evidence that markets look through stagflation.
Our Positioning
Humans tend to be better at creating narratives to explain the past and the present than they are at predicting the future. Accordingly, we construct portfolios based on evidence and not stories. No matter which beast rears its head, we believe our portfolios are positioned to perform. In fact, it’s the scenario in which there are no beasts that would be the most difficult for us on a relative basis, and the fortunate reality is that beasts have been relatively scarce for the last few years.
In our core model portfolio, we have exposure to the Magnificent Seven, just not as much as the S&P 500, for example. But we are far more diversified, and global, than that index. Our value tilt provides our clients with a margin of safety that is intended to take the sting out of market downturns, when growth darlings disappoint and their high valuations fall back to earth. It also tends to support performance during periods of inflation. Our small-cap tilt allows us to play offense during market expansions, and quality and international tilts also support performance while lowering portfolio volatility.
Lights Out
We do not make it a habit of trying to predict the future, but of course we observe there are certain cycles that seem to be unavoidable, such as lights out at 10:30 p.m. (right in the middle of Moonlighting, by the way!). Being exposed to that kind of discipline was not always fun, but I like to think it contributed to positive development over time.
The same goes for our approach to investing; we are not going to abandon discipline and wager the kingdom on a handful of risky bets. The evidence shows when it comes to investing that it is a better approach to live long enough to take lots of advantageous bets. It’s more akin to the fable of The Tortoise and the Hare than The Lord of the Rings, but the tortoise is still very much the hero. The tortoise defeats the beast and fulfills his quest, not by performing miracles but by doing the little things right and staying true to himself. That’s an epic journey if there ever was one.
The End
For more information, please reach out to:
Burke Koonce III
Investment Strategist
bkoonce@trustcompanyofthesouth.com
Daniel L. Tolomay, CFA
Chief Investment Officer
dtolomay@trustcompanyofthesouth.com
This communication is for informational purposes only and should not be used for any other purpose, as it does not constitute a recommendation or solicitation of the purchase or sale of any security or of any investment services. Some information referenced in this memo is generated by independent, third parties that are believed but not guaranteed to be reliable. Opinions expressed herein are subject to change without notice. These materials are not intended to be tax or legal advice, and readers are encouraged to consult with their own legal, tax, and investment advisors before implementing any financial strategy.
