Profitability validates U.S. stock market performance, but don’t discount the risks

There’s plenty for U.S. equity investors to be pleased about as we make our way through the second half of 2025. First and foremost, performance has continued to build to the upside after digging out of the deep-but-short-lived hole created by April’s tariff chaos.
We often remind investors during selloffs that we see declines every year, and yet annual returns for the S&P 500 have still ended up positive 75% of the time since 1980, as exhibit 1 shows. This is a much easier lesson to digest when we’ve already been rewarded for our patience, and this year looks on track to continue the pattern.

Exhibit 1: S&P 500 intra-year declines vs. calendar year returns since 1980

Returns represent price changes and do not include dividends. Source: Standard & Poor’s, Bloomberg LP, as of 8/31/25

We also see good news from a fundamental standpoint: corporate earnings have continued to run at a double-digit year-over-year growth rate, with the S&P 500 posting roughly 12% year-over-year earnings growth in the second quarter to follow the first quarter’s 13%. Healthy profitability lends justification to the stock market advance and helps support the case for continued optimism.

There has been plenty of optimism to go around in recent months. We’ve seen a rush of deals—initial public offerings, mergers and acquisitions—after a couple of years of subdued activity. These deals can present investors with newer, potentially more innovative opportunities, but we also need to be aware that they often come with a fair amount of hype.

Not all the lights are blinking green

In fairness, we see several reasons for caution right now. Earnings growth so far this year has been boosted by frontloaded purchases as businesses and consumers anticipated the highest average tariff rate in 90 years. We believe the full impact of tariffs on revenues and profit margins is likely still ahead of us given how long it has taken for trade deals to come together and the fact that a deal with China is still elusive.

Tariff uncertainty has now been compounded by recent court rulings that may undermine the Trump administration’s strategy of using temporary emergency powers as leverage for trade deals once appeals and back-up plans have been exhausted.

Aside from tariffs, we’ve also returned to a narrow market environment that’s being led primarily by AI-enabling companies, creating a major dependency and potential for disappointment if those companies falter.

Investors have also been willing to look past other risks: softening labor market conditions, shifting regulations, and an increasingly active role for government in business activities.

Lastly, we’ve grown accustomed to expensive valuations again, but there’s no denying that U.S. equities are pushing against historical extremes.

Exhibit 2: Large caps are generating healthy profits, but they’re expensive compared to history

Based on quarterly data from September 30, 2005 through September 10, 2025. Source: Bloomberg

It’s notable that the price-to-earnings ratio (PE) for U.S. equities has climbed so high despite the relief that earnings growth provides to the equation. At the highest level, the total value of the U.S. stock market has reached an all-time high as a percentage of GDP (exhibit 3). This all-in measure has been described by Warren Buffett as "probably the best single measure of where valuations stand at any given moment."

Exhibit 3: The U.S. stock market is expensive when measured against the U.S. economy

Monthly data from January 31, 2004 through September 9, 2025. Source: Bloomberg

Size may offer stability, but is the price too high?

Cooling employment and wage growth is forcing consumers to be more price-conscious at a time when tariff costs are putting upward pressure on prices. Exhibit 4 shows that the tariff cost burden being shouldered by U.S. consumers is expected to grow in the months ahead, which could end up detracting from corporate revenues. Businesses have already been bearing a majority of the upfront pain, while exporters have gotten comparatively lucky.

Exhibit 4: Division of tariff costs

As of August 27, 2025. Franklin Templeton Investment Solutions. *After all announced tariffs through June are in place for more than four months **The share of tariff costs borne by U.S. businesses is a net amount. Some businesses probably absorbed a larger share of tariff costs, while other businesses that competed with imported goods likely raised their prices.

In this case, we believe size equals greater stability. Large caps tend to be more global than smaller companies, offering a degree of insulation from U.S.-centric trends and potentially making them better “all-weather” performers.

Large caps have also been outearning their smaller peers over the past few years (exhibit 5). They owe a great deal of this earnings growth to the largest technology-oriented companies—with the Magnificent Seven increasing earnings at a 20% annualized rate over the last decade, while other AI companies have been running at about half that pace, and non-AI-related companies delivering roughly 6% earnings growth.¹

Exhibit 5: Large-, mid- and small-cap earnings

January 1, 2022 through September 10, 2025. Source: Bloomberg

Far from resting on their laurels, these top technology-oriented companies have been committing an increasing share of their earnings to capital expenditures. These investments in future growth from the Magnificent Seven account for one-third of all capital expenditures by S&P 500 companies, showcasing their commitment to sustaining growth and helping to justify their valuations.

Putting it all together: Balancing growth opportunities with an emphasis on valuations

There’s no question that the market leaders of the AI theme—the large language models themselves, semiconductors, cloud computing and data centers—are changing the way we work and live. The fundamentals prove it too, as these companies continue to lead in earnings and capital investment growth. Profits plus promise help explain why seven of the largest tech-oriented companies were responsible for 30% of the S&P 500’s return through mid-year.

Still, buying U.S. stocks at such high valuations has been statistically associated with lower returns over the following years. And while small- and mid-cap stocks have been comparably less profitable in recent years, and may be more sensitive to any downshift in U.S. economic growth, they currently offer more attractive valuations compared to their historical ranges.

In short, there are pros and cons across the U.S. capitalization spectrum—from mega-caps to micro-caps. We believe cautious optimism is warranted, and that select investment opportunities still exist, and we’re most intrigued when we can identify value in growing companies. That growth may be evident in top-line revenues, earnings, dividends, or cash flows. Growth potential may also be evident in companies that are reinventing themselves, gaining market share, successfully raising prices, or reordering their supply chains amid a complex realignment of global trade.

Looking across the broad U.S. equity opportunity set today, we continue to pursue a barbell approach combining high-quality growth tech stocks and stable, dividend-yielding stocks. The valuation correction earlier this year provided an opportunity to add to the growth side of the barbell, and we are vigilant in avoiding potential value traps on the stability side.

As always, we will carefully pick our spots—for example, when pullbacks temporarily offer more appealing prices on high-conviction stocks with long-term potential. We also caution investors to resist the urge to overpay, which grows stronger as market rallies persist, but ultimately tends to hold back performance.

 

 

 

1. According to FactSet data analyzed by 22V Research as of August 27, 2025