All Roads Lead to Diversification

Despite a record-long government shutdown, sagging consumer confidence and fears of a weakening labor market that led to three Federal Reserve rate cuts, U.S. and global equities pushed higher in the fourth quarter to end 2025 on a strong note. For the second year running, each of our nine broad asset classes finished in the black. Asset class leadership shifted in 2025, however, as international developed and emerging market equities claimed the top two spots for the first time since 2017. Emerging markets rose 4.73 percent in Q4, pushing the asset class’s 2025 total return to 33.6 percent, while international developed markets climbed 4.86 percent to finish the year with a 31.2 percent return. Importantly, a performance tailwind to each was a 9.4 percent decline in the U.S. dollar index, which helped amplify the local currency return of international developed stocks from 20.6 percent to 31.2 percent for U.S. dollar-based investors. This marked the largest annual decline of the dollar index since 2017, when it fell 9.9 percent and similarly boosted U.S. dollar-based international returns.

While international markets topped 2025 annual performance, another asset class that often benefits from a weaker dollar—commodities—was the best performing asset class in Q4, climbing 5.85 percent on the back of gold’s 11.5 percent rise while silver rose an astonishing 52 percent. Commodities finished 2025 up a strong 15.8 percent despite crude oil falling from 67.6 to start the year to 57.42 to end 2025. We believe two other asset classes possess diversification benefits: U.S. investment grade bonds and Real Estate Investment Trusts (REITs). The former rose 1.1 percent to finish the year up a relatively strong 7.3 percent, while the latter fell 0.79 percent in Q4 but eked out a 3.7 percent return for 2025.

U.S. Large-Cap equities were outpaced by international equities and did not occupy the top spot among our nine asset classes for the first time since 2022 but still provided compelling returns in both Q4 and 2025. The S&P 500 index of U.S. Large-Cap stocks rose 2.65 percent in Q4 and a strong 17.9 percent for the year. This advance comes on the heels of a 25 percent return in 2024 and a 26.3 percent return in 2023. As we have consistently noted, however, this performance has been driven by a narrow group of stocks largely tied to the artificial intelligence (AI) theme, with a historically low 29 percent of S&P stocks beating the index return in 2023, 28 percent in 2024 and 31 percent in 2025. The most recent figure marks the narrowest advance on record in data going back to 1973, rivaled only by the 1998 and 1999 figures, when the dot-com theme was similarly driving markets.

Unlike the previous two years, however, 2025 was not simply an Nvidia (NVDA) or Magnificent Seven story. Interestingly, while an equal-weighted index of these seven stocks did outperform the S&P in 2025 (ending the year up 24.9 percent), only two of the seven companies beat the index return: Alphabet (GOOG) (+66%) and NVDA (+38.9). That marks a major shift from entirety of the Mag Seven beating the index in 2023, and six of the seven in 2024, as the AI winners shift with the latest technology in a rapidly evolving value chain.

Despite this, we note that of the 11 sectors in the S&P 500, the two most closely tied to the AI theme—communication services and information technology—led the index for the third straight year. This has pushed these two sectors to account for nearly 45 percent of the index, with technology alone accounting for over 34 percent, eclipsing that of its previous high-water mark set back in 1999. Interestingly, according to Ned Davis Research, the weighting of NVDA peaked at 8.3 percent of the S&P 500 index in November, a level surpassed only by International Business Machines (IBM) in April 1973.

Once again, more economically and rate-sensitive U.S. Mid Caps and Small Caps underperformed their Large-Cap counterparts. Mid Caps rose 1.64 percent in Q4 to finish 2025 with a 7.5 percent return, while Small Caps advanced a similar 1.69 percent in Q4 and 6.0 percent for the year.

2025 marked another good year for investors and the benefits of diversification outside the U.S. Large-Cap equities began to grow as a fully diversified equity portfolio and outpaced the return of the S&P 500 largely on the back of international markets. We expect this trend to continue into 2026 as the U.S. equity market further broadens to include U.S. Small- and Mid-Cap stocks. Put simply, diversification worked in 2025, a trend we expect to carry into 2026.

Tariff Concerns Turn to Bubble Worries in Q4

Tariffs and their impact on the U.S. economy remained a key narrative, while an absence of official government data resulting from the government shutdown made it more difficult to measure the impacts of higher levies on the economy and markets. With those questions left unanswered, investors shifted their focus to another concern: whether U.S equity markets were in a bubble like that of the dot-com bubble of 1999. This debate has heated up given that U.S. equity markets are trading at their second highest level (excluding 1998 and 1999) on nearly every valuation metric. This fact, coupled with the heightened concentration in markets, has brought worries of circular financing and increased spending by members of the Magnificent Seven to a head.

We believe that how we arrived at the “AI theme” concentration in markets is reflective of the U.S. economy over the past few years. The U.S. economy has grown increasingly bifurcated. On one side, segments including housing market, manufacturing, smaller companies and lower-income consumers with variable-rate debt have felt the burn of higher interest rates. On the other, companies tied to the AI theme and higher-income consumers who have less debt and/or more appreciating assets have benefited from recent monetary policy.

Interestingly, consumer sentiment soured sharply during the fourth quarter even as the stock market hit fresh highs. The University of Michigan’s November Consumer Sentiment Survey current condition index hit its lowest level ever in data back to 1978 on “pocketbook concerns” such as potential rising unemployment, slowing income growth and still elevated and rising prices. Meanwhile, a competing survey from the Conference Board showed that 52 percent of respondents expect higher stock prices in the future, a level surpassed in data going back to 1987 only by a 57.2 percent reading in November 2024 and a 54.8 percent reading in December of 2024. This overall declining consumer confidence is reflected by the fact that the top 10 percent of consumers accounted for a record share of overall spending in Q2 2025, according to Moody’s analytics, while AI-related spending drove overall U.S. business-related capital investments (capex). Information processing equipment and software capex contributed a record amount to overall U.S. economic growth through Q3 2025.

This bifurcated and narrow economy has led to a bifurcated market that reflects the overall U.S. economy, given that corporate earnings growth has naturally risen the most among companies tied to the themes of AI and higher-income consumers, especially the Magnificent Seven, which has seen explosive earnings growth. The questions are whether or not this earnings growth is sustainable and how far into the future investors are discounting the profits with the current stock prices. Increasingly and somewhat concerningly, the AI theme is spreading into nonprofitable companies—not just ones that are posting strong cash flow and earnings. We note that a Goldman Sachs-created basket of nonprofitable tech companies rose 101.8 percent from the post- “Liberation Day” lows to finish the year up 46.7 percent in 2025, even after a 22 percent decline from October 15 to November 20. Remarkably, this coincides with the top news searches that match “market bubble.”

While the bubble chatter has pulled back recently, we believe that this discussion will likely ramp up again in 2026, as it continues to be one of the top questions asked by our advisors and clients. Is this a bubble similar to the dot-com era, and if so, what is the best way to invest? The bad news is that no one knows for certain whether an AI bubble is underway, and we will know the ultimate answer only in hindsight. The good news is that regardless of the answer, there is a clear path to navigating this uncertainty: returning to the fundamental playbook of diversification—not concentration and excess speculation—while maintaining an intermediate- to long-term investment horizon. This is what worked for investors after the dot-com era, and we believe it will work no matter what the answer to the question becomes in 2026 and beyond.

While past performance is no guarantee of future outcomes, the chart below shows the results of a study comparing those who invested across a broad spectrum of global equity markets, similar to our diversified equity allocations today, versus those who chose to concentrate only in certain segments of U.S. equity markets, most tied to the dot-com stocks. This study starts by investing $1 million in these different “portfolios” in March of 2000, when the prior dot-com bubble hit its peak, and is updated and rebalanced at the end of each subsequent month.

While past performance is no guarantee of future outcomes, the chart below shows the results of a study comparing those who invested across a broad spectrum of global equity markets, similar to our diversified equity allocations today, versus those who chose to concentrate only in certain segments of U.S. equity markets, most tied to the dot-com stocks. This study starts by investing $1 million in these different “portfolios” in March of 2000, when the prior dot-com bubble hit its peak, and is updated and rebalanced at the end of each subsequent month.

The three yellow lines represent concentrated segments of the markets where the dot-com bubble was most prominent: U.S. Large-Cap technology stocks in the S&P 500, the tech-heavy NASDAQ composite index and the S&P 500 itself, which in Q3 of 2025 finally surpassed its 1999 previous record weighting to the technology sector. The blue lines represent what we believe to be a prudently diversified global equity portfolio, with the dotted blue line having 42 percent in the S&P 500 (U.S. Large Cap), 11 percent in the S&P 400 (U.S. Mid Cap), 5 percent in the S&P 600 (U.S. Small Cap), 7 percent in the Dow Jones U.S. Real Estate Investment Trust Index, 24 percent in MSCI EAFE Index (International Developed Market Equities) and 11 percent in the MSCI Emerging Market index. The dark blue line simply replaces the market cap-weighted S&P 500 index (35 percent of which is concentrated in technology stocks) with an equal-weighted version of the S&P 500, further removing the concentration in the largest stocks, where the top 10 names dominate the weightings (over 40 percent today) of the overall technology sector. As you can see, while all portfolios experienced losses, those that were more diversified experienced fewer losses and outperformed for many years to come.

Put simply, this is a reminder of the old adage to not put all your eggs in one basket. No one can time the market, and no one should attempt to time a potential bubble. The reality is that you need stay invested and, most importantly, stay diversified.

The Other Big Questions of 2026

There are many other questions that remain in 2026. Most notably, we believe that we have yet to see the full impact from tariffs given their delayed implementation and the reality that imports and inventories were pulled forward while consumers bought ahead of tariffs. The effective rate on imports into the U.S. started 2025 at 2.3 percent and climbed to 10.65 percent in September, according to the Penn Wharton Budget Model. Estimates put that rate at around 1416 percent once tariffs are fully implemented. While this falls short of the 28–30 percent rate that was proposed on “Liberation Day,” we note that when they get to their final resting spot, they will be the highest since between 1935 and 1940.

For now, investors have responded to the pullback from the proposed “Liberation Day” levels and the reality that the U.S. economy has appeared to remain resilient in 2025 by pushing equity markets higher. However, as we exited 2025, the U.S. labor market was showing increasing weakness as the unemployment rate rose from 4.1 percent in June to 4.4 percent in December, while the three-month average pace of non-farm payroll job gains according to the Bureau of Labor Statistics (BLS) labor report fell to a negative 22,000, with the six month at a mere positive 15,000. On the opposite side, inflation appeared to pull back slightly but remained stuck above the Fed’s 2 percent target.

We continue to believe that there are risks to both higher unemployment and/or higher inflation in 2026, a view that is shared by the U.S. central bank. Despite these dual-sided risks, the Fed chose to cut short-term interest rates by a total of 0.75 percent in late 2025. Most importantly—and unlike late 2024, when they cut short term rates by 1 percent—intermediate- to longer-term interest rates remained steady to lower, with the U.S. 10-year Treasury ending the year at 4.17 percent, down from 4.57 percent to begin 2024. This is in contrast to the cuts in late 2024, which actually served to push rates higher, ending the year at 4.57 percent versus 3.88 percent at the start of the year. This pullback in rates will likely begin to help parts of the economy that have been impacted by higher rates, likely not only broadening out the economy but also the markets in the coming years. We also note the impacts of the One Big Beautiful Bill Act (OBBBA) will start to hit in the form of larger tax rebates and deregulation, which will likely be a stimulus to the economy.

All Roads Lead Back to Diversification

We continue to believe that the U.S. economy and market are in a delicate balance. We remain concerned about the bifurcation in the economy. The biggest question, as to the current state of the labor market, remains, which is causing little angst among investors despite its weakness. On the opposite side, if the labor market restrengthens, it is likely that inflation embers could reignite given that we are in a later-cycle economy. This is the delicate balance the Fed is attempting to navigate, with the arrival of a new hair in May adding to that uncertainty. Questions also remain over the legality of tariffs issued under the International Emergency Economic Powers Act; a topic currently being deliberated by the Supreme Court. The mid-term elections in November could reshape power in Washington, which in turn shapes the economy.

We also worry about the elevated valuations in the equity market and note that while this is a poor timing tool, it has at least historically been a good determinant of relative intermediate- to long-term future returns. The good news is that despite parts of the market that appear expensive, others are cheap. We continue to note that both U.S Mid- and Small-Caps trade a valuation discount similar to those back in 1999. Importantly, we note that earnings estimates are finally increasing for the companies, likely on the back of lower interest rates. We also believe the AI winners will shift as we move along the various phases to bring this technology to life, with the benefits ultimately accruing overall to the U.S. economy and the broader set of companies that use it to increase the productivity of their workers and profitability of their companies.

While we worry about longer-term interest rates and the path of inflation, the reality is that bonds continue to offer yields on investment-grade paper around 45 percent. Even with sticky inflation, these bonds are offering positive real returns. We continue to believe that fixed income has returned to its historical role of hedging downside risks in both the economy and the markets, a development that will prove helpful should the economy and markets experience a hiccup in 2026. While it is likely that 2026 with take many twists and turns, some of which may not even be on investors’ radar today, we continue to note that the way to navigate this uncertainty is the same as it has been for decades: diversification and adherence to a financial plan. While diversification can go in and out of favor over shorter time horizons that are impacted by themes, history has proven its worth over intermediate to longer periods of time, with their unexpected shifts in the economic and market backdrop.

We believe history often repeats itself because it was written by humans who have the same behavioral flaws as those who are writing it now. Diversification is not only risk management but can also be return enhancement from the strategy many want to follow of investing only in the S&P 500.

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