A market under no obligation to make sense
The third quarter of the year picked up where the second left off, with equities continuing to rally, hitting fresh all-time highs. A rate cut—and talk of more cuts—helped boost Small Cap stocks, which had previously lagged. But perhaps the defining feature this year has been the weakness of the US dollar juxtaposed with the strength of gold. The two moves are somewhat related and provide a real-life example of why a truly well-diversified portfolio, free from the trappings of home bias, is so important.
The Fed cut rates for the first time in over a year
After over a year of waiting, the Fed cut interest rates by 25 basis points in September, and an additional cut is expected before year-end. Inflation continues to be a thorn in the Fed’s side and has been the primary cause of the delay. Inflation has faced upward pressure from tariffs, tightened immigration policies, and tax relief. As a result, inflation has remained rangebound, hovering between 2.5% and 3%.
The Fed would prefer inflation closer to 2%, but its dual mandate requires balancing inflation and employment. Recent employment data has shown signs of weakness, despite an otherwise buoyant economy. Rate cuts take time to influence economic activity, and with this cut, the Fed aims to avoid falling behind the curve.
Chart 1: Rate cuts have begun
Source: The US Federal Reserve, Bureau of Economic Analysis
First-half Small Cap weakness has begun to reverse
US Small Cap stocks lagged their Large Cap peers meaningfully in the first half (and for the better part of the past five years for that matter). Large Cap performance has been driven by the Magnificent Seven (or Eight perhaps?) as the Technology giants have outpaced the rest of the market.
That trend paused in Q3 as Small Cap stocks outperformed. One likely driver is the recent rate cut as well as talk of additional cuts to come. A reduction in interest rates has the potential to benefit smaller companies proportionally more than larger ones. Smaller companies are more likely to rely on shorter-term debt funding, and floating-rate debt. As a result, when rates fall, these small companies have the potential to benefit proportionally more from the cheaper, short-term funding.
Time will tell if future rate cuts materialize, and if they can sustain Small Cap’s third-quarter performance trends.
Chart 2: Cuts have benefited Small Cap stocks
Source: S&P 500 (large cap), S&P 600 (small cap)
All-time highs, and valuation concerns
There have been a number of headlines about the number of all-time highs in equity markets this year. All-time highs are typical in healthy markets, so are not in themselves any cause for concern. The US equity market has a history of going up more than it goes down (that’s why we invest in it) and a natural result should be frequent all-time highs. But valuation is important as well.
A look across equity markets shows US Large Cap stocks stand out, trading at a notable premium to their pre-Covid median. We looked at the decade before Covid and found that the S&P 500 trailing 12-month Price-to-Earnings (PE) ratio is currently at a 63% premium to its median. But it is fairly unique in this respect.
By comparison, the equal weight version of the S&P 500 is trading at only a 25% premium. The reason is that this variation is less impacted by the expensive Mega Cap Tech stocks which dominate the S&P 500. Perhaps more striking is that the S&P 600 (Small Cap) trades at just a 5% premium to its historical median.
So, is this a moment to exit US Large Cap? Not necessarily. Markets can remain ‘expensive’ for extended periods. Alan Greenspan famously coined ‘irrational exuberance’ in 1996, years before the market eventually peaked. And in contrast to the dot-com bubble, today’s ‘expensive’ tech companies generally are highly profitable. In our opinion, proper diversification—rather than market timing—is a better approach. That holds true whether the US market is expensive or not.
Chart 3: US Large Cap appears uniquely expensive
Source: LTM PE of S&P 500 index, S&P 500 Eq Wt Index, S&P 600 Small Cap Index, MSCI EAFE, MSCI EM
US dollar weakness overshadowed by Gold’s strength
The weakness in the US dollar was a defining feature of the first three quarters of 2025, but it was overshadowed by gold’s continued strength. The two moves are intertwined.
The US dollar has declined about 10% versus a basket of global currencies thus far this year. The weakness stems, in part, from a rising fiscal deficit, policy uncertainty, and expected Fed rate cuts. The implications have been felt most notably in international investments. Both developed and emerging market stocks significantly outperformed US stocks through September. Part of that relative performance is directly attributable to dollar weakness.
Gold, on the other hand, has continued to perform strongly. Demand for gold has increased, in part, due to the weak dollar, rate cuts, global central bank buying, and its role as a safe haven in uncertain times.
A well-diversified portfolio, with exposure to international markets and commodities like gold, has the potential to capitalize on both these trends.
Chart 4: Dollar weakness and gold strength
Source: ICE US Dollar, Gold New York Spot
Gold and international strong amid a weak US dollar and tariff uncertainty
US Large Cap has had an excellent year so far, but diversifiers have been the star performers in 2025. Here are the highlights:
- As discussed above, gold is the standout performer, up 47%, thanks in part to the weak dollar, rate cuts, global central bank buying, and its continued perception as a store of value in volatile times.
- International stocks significantly outperformed domestic stocks, helped by better valuations and currency effects.
- Despite a solid Q3 as rates come down, tariff fears held back US Small Cap stocks. While the S&P 600, shown below, is up only 4% on the year, another broad Small Cap index—the Russell 2000, is up over 10%.
- US bonds produced positive returns, providing portfolios with both stability and income.
Chart 5: Year-to-date 2025 asset class roundup
Source: Factset
“The universe is under no obligation to make sense to you.” – Neil deGrasse Tyson
As we exit the third quarter with multiple asset classes at or near all-time highs, the question on many investors’ minds is: “Can it continue?” It can… but it is under no obligation to.
Making sense of a market determined to rise
In my free time, I often indulge my inner engineering nerd—whether it’s tackling DIY renovations or tuning into StarTalk with Neil deGrasse Tyson. If you listen to Neil long enough, you’ll hear him say, “The universe is under no obligation to make sense to you.” It’s a reminder of how complex systems—like the cosmos or the capital markets—can behave in ways that defy our expectations.
It may seem logical to sell when markets reach all-time highs. But history tells a different story. Momentum is a powerful force. What goes up often continues to go up—at least for a time. All-time highs are not rare, and they are not a signal to retreat. They are simply part of the market’s natural rhythm.
Eventually, we will experience another pullback, correction, or bear market. That, too, is normal. The key is preparation—not prediction. Now is a good time to ensure that the remarkable strength of US Large Cap stocks—especially the surging Mega Cap Technology names—hasn’t quietly overwhelmed your portfolio over the past five years.
Our evidence-based approach helps clients maintain well-diversified portfolios that avoid common pitfalls like home bias and concentration risk. While we continuously evaluate the data to guide our tactical positioning, our current approach includes:
- Diversifying across international equities, bonds, gold, emerging markets, and small caps
- Tilting toward areas with historical strength in similar environments, such as momentum stocks and gold
- Avoiding speculative assets and trend chasing, especially those with high risk of permanent loss
- Resisting emotional market timing
- Staying ready with sophisticated trading systems to: 1) systematically sell high and buy low as markets fluctuate, and 2) act swiftly to capitalize on major market moves
Each of these steps is designed to incrementally tip the odds in favor of our clients. The consistent and disciplined pursuit of these small advantages is what we call evidence-based investing. It’s the foundation of our philosophy—and our preferred approach in uncertain times.
As we look ahead to the final quarter of the year, I want to thank our clients, friends, and families who have joined the Strategic community and placed their trust in us. The future is always uncertain, but we’re honored to face it together.
About Strategic
Founded in 1979, Strategic is a leading investment and wealth management firm managing and advising on total client assets of over $2.5 billion.
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