A widening equity recovery with pockets of risk

Matt Stucky is the chief portfolio manager at Northwestern Mutual Wealth Management Company.

Equity markets have moved sharply higher over the last six months, fully recovering from the downturn triggered by April’s “Liberation Day” tariff announcements. Improving investor sentiment, renewed monetary easing and a de-escalation of trade tensions have been the primary reasons for this strong snap back. Given the strong recovery, we’ve been asked if the market’s response is overdone: Where are the risks, and where are the opportunities?

We’ll start with the positives. For the first time in two and a half years, we are seeing a widespread earnings recovery across the equity landscape. Previously, earnings growth had been narrowly focused as tight monetary policy harmed the corners of the economy that were more interest rate- and economically sensitive. Meanwhile, “secular growth” areas—like technology companies associated with the artificial intelligence capex boom—were delivering dominant earnings growth and market-leading performance. Directionally, this performance leadership profile makes sense, as investors tend to gravitate toward areas of the market that are delivering the strongest fundamental growth in the shorter term.

Since April, though, renewed easing from the Federal Reserve and the passage of fiscal stimulus via the One Big Beautiful Bill Act have helped broaden the earnings growth picture across the equity landscape. Technology stocks continue to generate impressive growth, but unlike in the last two and a half years, that growth is not occurring in isolation. Small-Cap earnings growth is now rising at a faster clip than that of their Large-Cap counterparts—a critical change from the last few years of frustrating performance for smaller stocks.

This stronger and more widespread earnings growth environment—combined with a declining interest rate environment as investors priced in a more dovish posture from monetary policy makers—provided the foundation for a strong equity rebound. Yet we also see some emerging risks when we look closer at market conditions.

From a factor perspective, momentum has been the driving force behind the equities leading the market since the summer. Increasingly, this momentum dynamic has lifted more speculative areas of the market without much distinction on either quality or valuation attributes. Put another way, momentum leadership that isn’t supported with strong fundamental performance is a potential risk going forward. Strong momentum factor performance has also come at the expense of quality and value factor performance, further raising our concerns about the staying power of the types of stocks currently leading the market.

The Bloomberg Quality factor had positive performance heading into the April tariffs announcement but then reversed sharply, declining nearly 13 percent through the end of October. The AQR Quality Minus Junk factor experienced a similar drawdown to its comparable Bloomberg factor through July (adjustments made for monthly frequency, data limited to 7/31/2025).

To gain greater insight into current market dynamics, we have dissected the Quality Minus Junk factor into its underlying components—profitability, growth and safety—by utilizing the Bloomberg factor analysis. Both profitability and growth, measured by five-year Compound Annual Growth Rates across multiple profitability factors, have underperformed since April but to a lesser extent than safety: The safety component, defined by lower price and earnings volatility, has significantly lagged. This performance suggests that investors are prioritizing high-risk, high-beta exposure more than they are focusing on companies with strong earnings quality and improving fundamentals—a clear indication of the prevailing momentum-driven environment.

Value lags despite improving earnings growth

Alongside the difficult environment for quality investing, value factor returns have also been challenged while momentum has remained in the driver’s seat. This dynamic is typical, as momentum and value factor returns tend to be negatively correlated. However, it is interesting that value returns have continued to lag despite a more robust earnings growth backdrop that continuously improved throughout the summer.

To illustrate the challenging value factor environment, we constructed an equal-weighted portfolio of S&P 500 companies that were either nonprofitable or had a valuation three times as high as the corresponding sector average. From a value factor context, one would expect the relative performance of this portfolio to be unfavorable over intermediate to longer periods of time—but precisely the opposite has occurred during the summer. Expensive and nonprofitable companies have dominated the performance of the equal-weighted S&P 500. Again, we question the sustainability of a market trend that is led by expensive or nonprofitable exposures.

Enhancing diversification by rebalancing away from momentum

The sharp rebound in the equities market has been driven by a more positive earnings backdrop and renewed policy easing from the Federal Reserve that has lifted investor sentiment. When we look deeper into market data, we see that strong momentum factor returns have led this positive performance. However, momentum factor performance can be just as powerful on the way down as it is on the way up.

That’s why it is critical to diversify momentum factor exposure with factors like quality and value. And because both quality and value have been laggards over the summer, investors have an opportunity to lean in toward those exposures to help rebalance a portfolio away from momentum—which increasingly comprises expensive and nonprofitable positions.

Another reason to look for diversification opportunities: We might finally see broader market participation if the improving fundamental breadth in the market persists into 2026. Fewer than 28 percent of S&P 500 members outperformed the cap-weighted index in 2023. In 2024, 32 percent outperformed. And through October of this year, 33 percent have outperformed. Yet each figure is well below the 48 percent long-run average.

Narrow earnings growth has been the dominant reason for this narrow band of outperforming stocks—but that trend may be shifting as earnings growth improves across the U.S. equity landscape. A reversion to a more typical percentage of S&P 500 members that outperform the index will benefit investors who maintain broader exposure to U.S. stocks beyond the high-beta/high-risk secular growth companies that have led the market for the past two and a half years.

The opinions expressed are those of Northwestern Mutual as of the date stated on this material and are subject to change. There is no guarantee that the forecasts made will come to pass. No investment strategy can guarantee a profit or protect against loss. Past performance is no guarantee of future results. This material does not constitute investment advice and is not intended as an endorsement of any investment or security. Information and opinions are derived from proprietary and non-proprietary sources. To learn more, click here.

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