The year 2025 had more than its share of ups and downs, but in the end, it should be remembered as a profitable year for both the stock and bond markets. This update will take us on a walk through the year focusing on events that affected the financial markets.
A Strong Start Turns Uncertain: Early 2025 Market Volatility
The year began positively as optimism tied to artificial intelligence (AI), corporate earnings and expectations of Fed rate cuts led to early returns. By February 19, the S&P 500 found itself up 4.63%, led by big tech and AI-related firms. The market then cooled as tariff fears began to emerge and the Fed hinted it would be patient about cutting rates. Uncertainty grew as the size and scope of proposed tariffs changed daily. By the end of the first quarter, the market had given back all its early gains and was down 4.27% for the year.
Liberation Day and the Q2 Market Rebound
Yet the downturn had just begun. On April 2, Liberation Day, sweeping tariff policy announcements triggered the largest global decline since the 2020 pandemic. The market fell 11.49% from April 1 through April 8. This put the S&P 500 down 14.98% for the year. Small caps, as measured by the Russell 2000, were down much more (20.76%). Then something changed. Investor sentiment turned positive as policymakers signaled delays or reductions in tariff implementation, driving a sharp rebound in the market. Progress in trade negotiations led investors to believe that the damage inflicted by tariffs would be much less than originally feared. By the end of the second quarter, all the losses had been recovered and then some, as the S&P 500 gained 10.94% in Q2 and was up 6.20% for the first six months.
A Maturing Bull Market and Federal Reserve Rate Policy
As the third quarter began, the market was clearly in risk-on mode. No matter what the news, investors viewed the glass as half full. For instance, signs of a cooling labor market were taken in stride as it increased the likelihood that the Fed would lower interest rates. Despite this slowing economy, earnings continued to exceed expectations, pushing the market higher. Investors finally got their wish when the Fed cut interest rates by 0.25% on September 17 and gave guidance that there would be additional cuts. Economically sensitive companies, especially in the tech sector, rallied strongly. The S&P 500 gained 8.12% in Q3, bringing its year-to-date return up to 14.83%.
The fourth quarter saw more resistance, yet the market continued to push higher. It is clear that we are in a mature bull market, where gains are harder to come by. The Fed came through with two more 0.25% rate cuts in Q4, although they are once again touting patience and are likely to pause their easing cycle for at least a meeting or two. The market had numerous weeks where it took a breather, reacting negatively to macro and geopolitical issues, yet in the end, it kept trudging higher. In this quarter, investors favored profitable, high-quality companies. This was not the case most of the year as low-quality, even unprofitable companies, outperformed. The fourth quarter was the first time since Liberation Day that speculation was not widely rewarded. The S&P 500 was up 2.66% in Q4, bringing its total return in 2025 up to 17.88%.
International Equities and Bonds Boost Portfolio Returns
This recap focused on the U.S. stock market. I would be remiss not to mention the international markets and the bond market. One of the main stories in 2025 was the return of international investments as they outperformed the U.S. markets by a considerable margin. The EAFE Index, a measure of developed market equities outside the U.S. and Canada, was up 31.24% and the Emerging Markets Index was up 33.53% in 2025. There were a number of factors that led to this outperformance including currency effects as the U.S. dollar weakened considerably, positive economic surprises among major economies, and cheaper beginning valuations. These factors led to broader confidence in the global markets. Notably, the factors that led to international outperformance still exist and have the potential to continue in 2026.
Bonds were also a positive contributor to portfolio returns in 2025. The Bloomberg US Aggregate Bond Index, the broad measure of the U.S. bond market, was up 7.30% in 2025. All major U.S. bond categories posted gains in 2025 including high-yield (8.62%), mortgages (8.58%) and municipals (4.25%). Interestingly, returns were strong with yields ending the year close to where they began it, which shows the importance of the starting yield. Bonds entered 2025 with yields around 4-5%, which is historically high compared to the last fifteen years. Investors earned this yield on their bonds throughout the year, which accounted for most of the return in the asset class. The rest of the year’s return can be attributed to investors paying a premium for non-Treasury bonds and historically low default rates. Just like U.S. equities, bonds are expensive today, but a yield above 4% is a much better starting point and provides a buffer should the market reverse.
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The Case for Diversification Heading Into 2026
The year 2025 proved to be a testament to the value of diversification. Contributions to returns came from many different sources. International equities, large-cap tech stocks and bonds all led the way at different points in the year. We feel diversification remains prudent going forward. We have now seen the S&P 500 have three straight double digit return years and the index looks expensive (trailing P/E of 31 versus historical average around 19). Some markets look more attractive from a valuation perspective (international and small caps) while other asset classes (bonds) could offer protection should equities’ three-year run come to an end. We are not predicting a rough year in 2026 as there are lots of positives heading into the year (growing economy, fiscal stimulus and a friendly Fed). Yet the direction of the market can turn on a dime, and we are not willing to take undue risk. Enjoy the spoils of 2025 as we prepare for what lies ahead in 2026.
Data Source: Morningstar
