Overview- 2025 was a good year for risk assets. The market moved into a choppy range bound trade during the 4th Quarter, as concerns over valuation in the AI space put a lid on the rally for the year. Our outlook for 2026, based on current expected earnings forecast and underlying fundamental strength in the economy, is a continuation of higher equity prices. The consensus outlook by Wall Street heading into the year calls for a reacceleration in the real economy — propelled by tax-based stimulus and an administration desperate to “run it hot” — which has quickly been reflected in market leadership. The Fed has been easing since late 2024, and it is expected to ease a couple more times in 2026. Trump is expected to pick a “dove” to lead the Fed after current Chair Jerome Powell leaves in May. Fiscal policy is on a path that will widen the deficit but can only be characterized as stimulative, which would obviously be positive for the economy.
The US economy continues to muddle along in a “K” economy where the top wage earners and savers are doing much better than the rest of the population, pinching spending power for the lower K. However, even that may have a silver lining as the current administration considers more stimulative actions to drive prices of goods, and food and services lower (not a surprise in a mid-term election year). Earnings are expected to be up again in 2026 as the economy continues its modest growth trajectory and the inflation outlook seemingly contained and slowly moving down towards 2.5%.
While our current outlook is positive, there are some concerning market metrics which we are watching. Valuation would be the obvious culprit, with the market at levels consistent with previous secular highs. However, we will reiterate once again – and we have seen this in real time – valuation is not a good timing indicator, only a weighing mechanism of potential future long term returns. While valuation on the capitalization weighted indexes is being skewed by the Mega caps run over the last 2 years, we still see valuations in non-tech, value, international and mid/small cap as more attractive so hopefully a diversified portfolio will help blunt the pain if valuation becomes a concern. On a shorter-term basis, the case for sentiment being a little too enthusiastic could be made. We monitor many measures of market sentiment, and most measures are running slightly overbought, not terribly dissimilar to last year at this time. While we are not looking for another tariff-led pullback of -20% like last year, the setup is similar, so some sort of pullback would not be a surprise, but we would view that as a buying opportunity if it occurs.
Another possible fly in the ointment is that there is a seasonal tendency for the second year in the presidential cycle (mid-term elections) to be weak (2022 was the last example). Historically, this seasonal weakness is strongest from May to October, so while we don’t place a lot of significance on seasonal tendencies, we do have it on the radar.
Trading Discussion- During the 4th quarter we reduced our beta from 108% to 100% as we started to receive some initial readings of a loss of momentum in the market along with overbought readings in sentiment. As the market bottomed going into year-end, we increased beta back to 108%. We also increased our exposure to commodities (currently at 8% in a variety of different managed vehicles along with gold and gold miners) as our current view anticipates a weaker dollar and stronger gold and commodity prices while global demand continues to remain strong. It is our view that as the bull market rally extends, valuation concerns for the mega caps are valid and we can find better value elsewhere. To that end, we added to our exposure in small and midcaps of around 12%, and international at around 14%. These areas are starting to show signs of relative strength, and we are anticipating adding more exposure if this trend continues.
In Fixed Income, we made significant changes to our taxable portfolios. We initialized exposure to the Tax-Exempt municipal market. This portion of the bond market is finally cheap enough, and yields are high enough for us to increase exposure. The taxable equivalent yields are very attractive, and we added exposure to municipal’s at very favorable levels. This move has improved the yield in portfolios while keeping quality at the same level or higher.
Outlook- There’s not much to quibble with in the market’s to-and-fro oscillations among sectors and themes so far in 2026. Indexes making record highs is more a bullish sign than a warning. Earnings forecasts are likewise near an all-time peak for 2026, though in recent days have inched a touch lower. Financial conditions are loose, and while the Fed appears on hold for January, the baseline expectation for a refreshed consumer and ongoing capex boom means the market should require less Fed help. When price action is crisp and the fundamental story solid, the main hazards become overconfidence and overvaluation that can result from an over-extrapolation of positive macro trends.
Conditions continue to remain favorable for equities, in a scenario that could be described as Goldilocks. We recognize that making such an observation while sentiment is elevated, and valuations are also extended, could be problematic. This is the conundrum we are in now: at the top of a bubble everything feels great. But we suspect that we are still in the sweet spot and that sentiment conditions, while elevated, are not as extended as they were in previous tops like in 2000, and earlier this decade after the post-covid rally in 2021. The key will be to identify when sentiment becomes “too bubbly” and look for a break in the uptrend to signal the start of a pullback of significance that would require defensive action on our part.
