BY: Jim McElroy
Ring Out the Old and Ring in the New
Here we are again at the intersection of two years, one old and familiar, if not completely understood, and one unknown but open to reckless prognostication. At this time last year, we boldly speculated that 2025 would prove to be an “interesting” year. This vague descriptor seemed appropriate: the return of Donald Trump to the presidency, after a four-year hiatus, implied a sharp departure in policy and predictability from any of his post-war predecessors. Donald Trump’s affinity for disruptive statements and actions has made us wary of policy missteps. In the event, we both under- and overestimated Trump’s disruptive effect on the economy and the markets. On the negative side, the president’s unilateral imposition of record tariffs on our trading partners raised both wholesale and retail prices, creating considerable confusion for a Federal Reserve bent on bringing inflation down below its 2% target. In addition, Trump’s threat to fire Fed Chairman Powell for not lowering the Fed funds rate, provided great angst for the fixed income and equity markets. On the positive side, Trump demonstrated tariff flexibility in extracting more favorable terms from our trading partners. The tariffs are still damaging to prices and corporate profitability, but the pain has not been as great as feared. In addition to some moderation in tariffs, Trump managed to push through Congress a substantial tax cut, which may produce good economic results in the coming year.
The markets during 2025 reflected both the fears and cheers of the Trump effect. The S&P 500, after reaching a record high in February of 2025, gave up 27.7% (technically a bear market) through early April on the basis of Trump’s imposition of the highest tariffs in over a century; the index then began rising on a combination of Fed rate cuts and moderation in tariff threats and actions. The S&P 500 set a new record high in December of 2025 (an increase of 38% from its April low). The appreciation in the S&P 500 for the full year of 2025 was 16.4%, including 2.3% in the fourth quarter.
Interest rates over 2025 largely obeyed the orders of the Federal Reserve. After maintaining its overnight rate at 4.5% for most of the year (January through August), the Fed resumed its rate cuts in mid-September and, in three .25% cuts, reduced the overnight rate to 3.75%. The market for government bonds, by and large, followed suit: except for yields on issues with more than ten years in maturity, rates have declined on average between .50% and .60% on the Fed’s .75% cuts. The result has been a steepening yield curve over the course of the year, a positive sign, though not an exuberant one, for the economy and markets in 2026.
The debate over expectations for the economy in the coming year is, as always, full of questions, contradictions, and guesses. The present isn’t always a prologue to the future, but it usually provides a baseline for judging when estimates of the future are overly pessimistic, reasonable, or wild-eyed crazy guesses. But this year, the baseline present is almost as uncertain as the future. Thanks to the shutdown of the federal government for almost half of the fourth quarter – October 1 through November 12 – many of the statistics that various government departments collect and publish have either not been published, published with suspect data, or may not be published at all. According to recent government communications, the Consumer Price Index (CPI) and the jobs/employment reports for October will likely never be released and/or are “permanently damaged”. Affected statistics include those for jobs, inflation, consumer spending, and GDP. We recommend that more than the usual grain of salt be taken with current statistics on the state of the economy.
Some of the more recent economic data and reports of alkaline provenance have been mixed. Personal Consumption Expenditures (PCE, the Fed’s preferred inflation statistic), for both all items and excluding food and energy, increased 2.8% on an annualized basis; the Fed wants it below 2%. Consumer sentiment, reflecting a weaker labor market and inflation concerns, is still quite low. Retail sales in September indicated a weakening in purchases. On the positive side, the latest report on initial claims for unemployment (week ending November 22) is at the lowest level since 2022. And GDP for the third quarter grew at a 4.3% annualized rate, the highest in two years.
The outlook for 2026, both in terms of the economy and the markets, of course, is murky. Even if the economic reports were complete and they’re not —they primarily depict a landscape that is anywhere from two weeks to three months in the past — helpful statistics, but vulnerable to revisions and surprises. The stock market itself is probably the most timely predictor of economic direction, though by no means is it infallible. Economist Paul Samuelson once quipped, “The stock market has predicted nine of the last five recessions.” He could also have said the same about bull markets and economic expansions. Certainly, the S&P 500 is far from predicting a recession, having set and broken several records over the last three months, but we wonder if the economy is as strong as the market suggests. At a P/E multiple of almost 26 times forecasted earnings, when the average over the last thirty-five years was 16 times forecasted earnings and the ten-year government bond was yielding, on average .49% less than the current 4.16%, one has to wonder what kind of growth in earnings is assumed by these premium earnings multiples. These comparisons are clearly conjectural, but they do highlight an exuberance for future economic growth that may be overstated.
Much of the exuberance in the stock market is, of course, due to the excitement generated by the promise of artificial intelligence (AI) and the almost daily reports of new creations and applications. Most of the 2025 return in stocks, despite some recent broadening of market leadership, has come from AI -connected companies. AI appears to be a technological development of historical significance, along the lines of the internal combustion engine, the telephone, and the wireless radio. If so, it will create many new businesses and careers while making many current businesses and careers obsolete. These changes and the anticipation of these changes could have dramatic effects on the economy: an increase in unemployment would adversely affect consumption, which represents about 60% of GDP. Of course, new technology also creates new businesses and careers. At the very least, we should expect volatility in the economy as businesses and individuals adjust to new opportunities and dislocations. This volatility will likely make its way into the financial markets.
2026, like 2025, will be an interesting year. Donald Trump is still president, and there’s little reason to expect him to be less controversial in 2026 than he was in 2025. The Supreme Court will rule on the constitutionality of his tariffs in January or February and we expect the fate of tariffs will create a great deal of excitement in the markets, no matter the decision. Trump’s challenges to the independence of the Federal Reserve will once again roil the markets as Chairman Powell’s term as chairman draws to a close in May. And let’s not forget that there will be midterm elections in 2026 that will determine control of the House and Senate. Actually, 2026 will likely be more interesting than 2025.
Happy New Year!
Not Investment Advice or an Offer
This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.
