***Q3 Client Update***
The third quarter of 2025 certainly had a lot going on, both in terms of geopolitical events, markets and the economy. Similar to Q2, the stock and bond markets were sanguine, rewarding investors who accepted varying amounts of risk with the S&P 500 up by 8% and the equivalent bond index (Barclay’s Aggregate) ahead by 2%. The economy continued to exceed expectations.
Coming into Q3 I expected a quieter quarter than we saw in Q2 in terms of market volatility and returns. I thought tariffs would have much less impact and the Fed would stand pat. I also expected Congress to pass an enormous tax and spending bill. After forecasting a 10%+ stock market correction by July 4th early in the year, I saw a mild 2-5% pullback for stocks in Q3.
There were many non-market moving geopolitical events in Q3. To start the quarter Congress passed the One Big Beautiful Bill (OBBB) which prevented the largest tax increase in history from happening. On the surface that was good and welcome news for the markets and economy. And although I have always supported lower taxes overall, I thought there was an opportunity to raise taxes on incomes above $1M since the economy was strong and that demographic has benefited the most from the markets.
Winners from the OBBB included U.S. manufacturers as well as taxpayers in high tax states like NY, CT, CA, NJ and IL as the state and local tax deduction was raised to $40,000 for earners less than $600,000. Taxes on social security, tips and overtime were reduced or eliminated for lower income earners for the next few years. And the standard deduction many Americans use on their taxes was raised. Overall, OBBB will likely have a positive impact on the stock market and economy, but a negative one on the bond market as the annual budget deficits will likely rise.
Elsewhere, the U.S. attacked Iran’s nuclear facilities after Israel softened the belly in Q2. The war in Gaza continued, but negotiations were ongoing on a ceasefire and exchange of hostages for prisoners. As hard to believe as it is, Israel will likely end up as the power player in the region with peace deals coming from Saudi and the UAE over the coming few years. Russia’s war against Ukraine also waged on in spite of repeated attempts by the administration to broker a peace deal. In an unusual 180, the Trump administration has turned sour on relations with Putin and began considering raising the stakes to heavily support and arm Ukraine to try and force the Russians to negotiate peace.
The Trump administration continued forging trade agreements with many nations, the biggest being Brazil in Q3. On our shores, we saw the National Guard called into Washington DC with more threatened action in other cities in Q4 to help combat what has been deemed a surge in homicides and crime. Deportations by ICE of alleged illegal immigrants also were a theme in Q3 with protests popping up around the country. This has the potential to negatively impact the economy if the numbers become critical mass, which I do not believe.
As you can imagine clients, prospects and friends often discuss politics when visiting the office or Zooming. Generally speaking, it seems like one third are strong supporters of Donald Trump, one third were strong supporters of Joe Biden and the remaining third fall in the neutral category. Over the years, I have heard every possible comment about both presidents and both parties. In my job it’s all irrelevant. You love one president. You hate one president. You love one party. You hate one party.
In the end, during my 38-year career, every single president has presided over all-time highs in the stock market and record economic output. People assign way too much blame and credit for the party in power and the president. People saying, “BUT, BUT, BUT” doesn’t work. The truth of the matter is that the Federal Reserve is probably 10 times more important than the president when it comes to the markets and economy.
Pivoting to the economy and markets, the Federal Reserve had their annual retreat in Jackson Hole where Chair Jay Powell finally floated the trial balloons for long-awaited interest rate cuts which should have started at the March meeting. Donald Trump appointed a new Fed Governor, Stephan Miran, just in time to not only support a rate cut at the September meeting, but also call for more than just ¼% and more cuts in the future. Miran is definitely an outlier with his views, but that’s likely the only way he would have been appointed in the first place.
The final reading for Q2 GDP growth came in at +3.8%, double economists original estimates. This has been a theme. So called experts have been surprised by the resiliency and strength of the U.S. economy. At the same time, the job market has softened, which is something I started writing about in Q4 2024. Furthermore, the Bureau of Labor Statistics updated its employment report for the 12 months ending March 31, 2025. It revealed that there were 911,000 less jobs created over that period than previously reported. This is not some politically driven economic data manipulation or conspiracy. Rather, as I have written about for years, it is the result of a very antiquated data collection system. Congress’ run by both parties have refused to approve the several billions of dollars requested and required to update or create a modern system to collect and analyze data.
When the final read for GDP growth in Q3 is released, I expect the economy to remain resilient and surprise to the upside in spite of lackluster job growth and tariffs. The beginning of deregulation created a strong economic tailwind for quarters to come. And speaking of tariffs, while I continue to vehemently oppose them as an economic tool, their impact has exactly as I have written and expected, minimal.
If I had a nickel for every time someone said that tariffs were going to cause “soaring inflation”, recession or another 2008, well, I would have an awful lot of nickels. The fact of the matter is that, as usual, the economists, pundits and media were dead wrong. Despite much revisionist history, these folks can’t hide from woefully pathetic and lazy analysis that caused the masses to liquidate portfolios in what I surmised was the single greatest panic selling event in history in nominal terms during the stock market’s early April tariff tantrum.
I remember arguing with a high-profile PhD pundit on TV who questioned my credentials in claiming that although I opposed tariffs, they would not be inflationary. And I agreed that he was way, way more intelligent than I was. My simple question was that if a pen cost $1 in 2024 and then a 10% tariff caused it to possibly rise to $1.10 if the tariff was fully passed along, what would the equivalent cost be in 2026? It would be $1.10 which would mean no inflation, just a flat 10% “surtax”.
In Q3, the government took an equity stake in domestic semiconductor maker, Intel, with Nvidia following suit in the same company. As you know, I am dead set against the U.S. government taking stakes in the private sector. It is cringeworthy and socialistic. And for the record, I was vocally against the government buying Fannie Mae, Freddie Mac and AIG as well. I vehemently opposed rewriting contract law with General Motors and bailing out Solyndra. I do not want the government to meddle in capital market business and pick winners and losers. I absolutely applaud Nvidia buying a stake in Intel. It’s a brilliant move for Intel and Nvidia.
As I already mentioned, the stock and bond markets rewarded the bulls in Q3. The same can be said in the metals markets. Bitcoin was modestly higher while crude oil was modestly lower. It is no secret that stocks are expensive by historical standards. By expensive, some people assume that because stocks are making all-time highs, they must be expensive. That’s not the case.
Valuation judges stock prices according to the earnings they produce relative to their prices. In the simplest terms, stocks are costly using metrics such price to earnings ratio. High profile Yale economist, Robert Shiller, has his own valuation metric called the Shiller Price to Earnings. That, too, tells us stocks are overvalued. Warren Buffet created his own valuation metric which measures the value of the total stock market to that of the economy. Guess what? The Buffet Indicator screams that the stock market is overvalued. So why am I not concerned about an imminent bear market? Because valuation and these models are absolutely terrible timing tools. They are often years early and best serve to provide caution, not an actionable portfolio move.
Finally, on the markets, we saw a 20% decline into the tariff tantrum low in early April. 20% declines are somewhat unusual historically, but more frequent of late. They were also seen in 2022, 2020 and 2018 which makes four in seven years. I sensed that after a 20% decline and subsequent rally to new highs, the stock market would be immune to another large decline. I looked at all of these declines since 1990, and I threw out 2000-2002 and 2007-2009 because the declines continued for years without a new high.
Research shows that another 20% decline did not begin for at least 1.5 years from the first new high in three cases. One case lasted two years and another lasted three years. The 2011 decline and new high insulated the stock market for almost six years although there were double-digit corrections in 2015 and 2016. Based on this limited research, the stock market should be on solid footing until at least the end of 2026. Of course, our models will always be on the lookout for signs of internal weakness and caution.
At this point in the report, I usually write about my barbell strategy for investing. If you picture a barbell from the gym, there is a long, thin bar with big weights on both ends. Think of those weights as our conservative strategies and aggressive ones, the exact proportions do not matter yet. In theory, your money would have higher weights to conservative and aggressive strategies, especially if you are in or very close to retirement, and lower allocations to the middle of the road strategies.
This barbell approach has also worked very well with monies being transferred in from 401K and 403b plans as those pre-packaged plans rely heavily on bonds for the more conservative approach and do not account for interest rates rising. Additionally, their aggressive choices do not usually reward the risk taken. If you would like to learn more about the barbell approach, we can set up a meeting, call, or Zoom.
The economy should continue to surprise to the upside as Q3 GDP is released in early Q4. When I think back to the soaring inflation of 9% and then the aggressive rate cuts by the Fed, it is amazing that the economy has been so resilient to thwart off recession when it was all but guaranteed. And after a negative GDP number in Q1, the economy grew at double the rate expected in Q3. At the same time, the anticipated employment soft patch has come to fruition. I wonder aloud whether we are going to see job growth bottom right now or somehow AI is already juicing the economy in a meaningful way without creating more than 100,000 new jobs per month. Three months from now, we should have our answer.
Regardless, a massive wave of deregulation from the One Big Beautiful Bill has started and that is likely to carry the economy well into 2026 where the next big election takes place.
I continue to believe that inflation is essentially dead. While I forecast some warmer data in Q3, I remain unbothered and believe that sustained inflation much above 3.5% is very unlikely until the other side of the next recession. The Fed chose a very arbitrary level of 2% as their goal without any data-driven studies to support that. Speaking of the Fed, another rate cut or two are on the docket for Q4. I do not believe this is part of major rate cutting cycle. Rather, another two or three cuts is all we will likely see until the economic data is substantially weaker.
Turning to the financial markets, Q4 has strong seasonal tailwinds. Without an exogenous event, it has been historically very difficult to see 10%+ stock market declines in Q4, 2018 and 2007 being the exception. In years where there is a significant correction, we usually see a strong performance chase in Q4 due to so many people liquidating positions into the decline, thinking there was more to come. They typically sit on the sidelines or under-invested until it’s clear they are wrong. By the time Q4 hits, they realize they are woefully underperforming and start to chase markets higher. Any and all bouts of weakness are quickly bought.
The stock market should close Q4 higher by single digits. The bull market should continue to broaden out and not at the expense of mega cap technology stocks. It is hard to watch, read or listen to the financial media without hearing about a “bubble” in something. Bubbles are generational and the term is the most overused in investing. Pundits who do so are lazy. I see plenty of greed, giddiness and euphoria in gold, silver, rare earths and AI. Those late to the party will almost certainly be punished sooner than later.
The bond market remains in a trading range which has nothing to do with what the Fed does or does not do. Long-term rates are set by the markets, and the Fed “usually” follows them. Three months ago, I viewed 4% on the 10-Year as a soft floor. The market should test that area in Q4 where I would rather sell bonds than buy more. I am looking for the top end of the range to decline.
Gold and silver went parabolic and should punish the bulls in Q4. Crude oil should test the mid $50s before finding a floor for a Q4 rally. Bitcoin is setting up for at least a short-term peak below 130,000. I would look for a soft floor below $106,000. The most important asset class to watch is the U.S. dollar which has global implications. Twice this year the index has visited the 96 area and rallied. It looks like the greenback is trying to bottom which would pressure other areas of the financial system, like gold, energy and other commodities, not to mention companies that derive much income from abroad.
Finally, please remember some of the opportunities at hand. We will do our best to harvest tax losses in taxable accounts. If you have IRAs, you should strongly consider ROTH conversions with the goal of having as much as possible in ROTHs during retirement. ROTHs are the single best account structure ever invented and far too few people take advantage of them. And I equally love ROTH 401Ks for your employer sponsored plan, especially for folks under the age of 50.
Updating your retirement projections is an invaluable tool, especially during periods of market weakness. Remember, we account for 10% declines, 20% declines and multi-year bear markets in our projections. Stock market declines reinforce our projection process. It is those projections that matter most over the long-term, not the day-to-day market volatility which causes discomfort for so many investors.
Please remember that while I publish regularly on the blog and speak freely in the media, our non-emotional, quantitative models dictate how each strategy invests, not my personal feelings or opinions. It is sometimes difficult when one group of models reduces exposure while another group remains in full steam ahead mode. I just keep my head down and follow what we built as best I can.
Please continue to share your feedback, positive and negative. Investing is a marathon not a sprint and the long-term future continues to look very, very bright. We look forward to sharing that with you over the coming years. And I am always interested in meeting, whether it is to create or update retirement projections on your financial situation, review the strategies in your portfolio, run social security analysis’ on when and how to file for the best benefit, discuss your estate or even smaller transactional-type issues like securing a mortgage or weighing insurance. Again, here is the link to my calendar to schedule a meeting in the office, call, Zoom meeting or Skype. https://schedulewithpaul.as.me/
Thank you for the privilege of serving as your investment adviser!
Sincerely,
Heritage Capital, LLC
Paul Schatz AIF
President
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