3rd Quarter 2025: Market and Economy

Nine months into 2025, headlines have been abundant—but so have returns. We’ve seen nonstop changes out of Washington, growing economic uncertainty, and an AI-fueled spending spree. So far, it has all led to another great year for the markets. The S&P 500 followed up a strong spring with an 8% third-quarter return, extending gains for the year to nearly 15%.

While mega-cap tech companies still dominate the headlines, we are seeing a broader rally than we have over the past several years. International stocks continued to post strong returns and are still leading the way for the year. The leading asset class this quarter, however, was small caps. The Russell 2000 gained over 12% and notched its first new all-time highs since 2021. Even bonds posted solid returns as interest rates fell ahead of the Federal Reserve’s September rate cut.

Shutdown Disruption, Not Disaster

After lawmakers failed to pass a stopgap spending bill on September 30, the federal government officially shut down at 12:01 AM on October 1. Essential services, such as the military, TSA airport security, and Social Security payments, will continue as normal, but many agencies have curtailed operations. The Congressional Budget Office estimates roughly 750,000 employees have been furloughed without pay.

The term “shutdown” sounds very dramatic, but such events are actually fairly routine in Washington. Government shutdowns are a strange quirk of US law and the current episode marks the 21st since 1976. The last shutdown started on December 22, 2018, and remains the longest on record at 35 days.

Two wrinkles could make this installment feel different: first, the Trump Administration has warned that some furloughed workers will be laid off if the impasse persists; second, economic reporting will be delayed, such as the September jobs report scheduled for release on October 3.

Historically, shutdowns have been relatively short-lived with limited impacts to the economy as furloughed employees receive back pay once Congress comes to an agreement. Interestingly, the S&P 500 has actually risen in each of the last five government shutdowns. Shutdowns are disruptive but have historically had limited impacts for investors. The real risk is in how long it takes for Congress to come to an agreement as sidelined government workers have bills to pay and families to feed.

Cutting with Caution

The Federal Reserve made its first rate cut of 2025 in September, trimming the Fed Funds rate by 0.25%. With both inflation and unemployment rising in recent months, the Fed is clearly showing more concern for the labor market. August unemployment rose to 4.3% (the highest since 2021) and June’s payroll figures were revised down to 13,000 fewer jobs than the previous month—the first monthly job loss since 2020 lockdowns. On inflation, Chair Powell noted tariffs are lifting some prices, but the Fed believes this is more a case of a one-time bump rather than the start of a new trend.

The Fed is currently expected to make two additional quarter-point cuts by year end but the government shutdown could complicate the matter if the data that policymakers use to make their decisions is delayed. Markets, which typically price in each data point in real time, will also be flying a bit blinder than usual until regular reporting resumes.

AI: Boom or Bust?

We’re getting more questions about whether or not we’re in an AI stock market bubble. The dreaded “B” word is always a bit tricky to talk about but let’s consider it by asking two important questions:

Question #1: Are we in an AI bubble?

To start, there is some real fundamental support for this bull market. S&P 500 earnings grew 12% in the second quarter, the ninth-straight quarter of growth, and current estimates from FactSet call for earnings to grow nearly 11% in 2025 and another 13% next year. Some of that high earnings growth is attributable to higher revenues, but a big driver is efficiency as profit margins have been trending higher for decades. In short, the businesses we invest in keep getting better at making money.

And many of those same companies are directing profits into AI. Amazon, Google, Meta, and Microsoft alone are expected to invest more than $360 billion into AI this year. That’s big money aimed at growing the bottom line.

At the same time, markets are rising even faster than earnings and stocks are looking pricey. The S&P 500 trades at 22.8 times forward earnings—implying 4.4 cents of profit for every dollar invested. Outside of price distortions during the COVID era, that’s the richest since the dot-com era.

You can’t say it’s a bubble for sure until after it pops, but today’s high valuations increase the odds that we’ll look back at this time as an AI bubble.

Question #2: If this is a bubble, what should we do?

This is the more important question and also where things get tricky. First, there’s almost always some kind of froth happening at any given time, from the internet boom to Beanie Babies to Bitcoin. The easy answer is “sell,” especially when you see quotes like this one from Jeremy Grantham, founder of GMO:

“The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history … sooner or later there will come a time when an investor is pleased to have been out of the market.”

I have a ton of respect for Mr. Grantham. He built up a successful firm and is extremely smart. He can also be very convincing and based on this quote, you could be swayed to sell out of all your stocks. The trouble is that he posted this in a piece titled “Waiting for the Last Dance” on January 5, 2021. Even with two 20%-plus selloffs, the S&P 500 has earned an impressive 87% net return over that time. The S&P 500 would have to fall by almost half just to get back to the same prices from January 2021.

Missing out on gains is usually more costly than holding through a downturn. That’s because to date, US markets have recovered from every downturn (knock on wood) but they rarely offer second chances for re-entry if you sell too early. And bull markets tend to run on longer than you expect, which can really compound a mistake if you are out of the market.

So yes, we’re staying invested but we’re also prepared for when things turn. There’s always a point at which excitement outruns reality; we just don’t know when that will happen. For our clients who live off their portfolios, our approach is simple:

1. Hold ample liquidity in cash and bonds to fund spending needs through a prolonged downturn.
2. Invest the rest into a diversified stock portfolio designed to compound over a lifetime.

The liquidity covers the bills during bear markets. The stocks, meanwhile, provide real long-term growth and ownership in the ongoing path of progress.

This information is believed to be accurate at the time of publication but should not be used as specific investment or tax advice as opinions and legislation are subject to change. You should always consult your tax professional or other advisors before acting on the ideas presented here.