After a year of twists and turns, the market staged a strong recovery in the second half of the year, ending up double digits again after a solid 2024. Robust earnings and interest rate cuts from the Federal Reserve drove enthusiasm, even as ongoing inflation and weakening jobs market drove lingering concerns. Importantly, the “AI trade” continued to deliver, buoyed by sustained demand from large tech companies investing in data centers as well as enterprises starting to find ways of using AI to boost productivity. This strength helped offset a pressured consumer environment, where higher prices and rising debt weighed on demand.
As we start 2026, this “tug of war” between corporate strength and a stretched consumer will be an ongoing theme to watch. One positive trend that’s emerged of late is a broadening out of the “AI trade” outside the tech sector, where a variety of companies are beginning to find tangible economic impact. So far, it is showing up in areas like logistics, retail, and financial services, but as more use-cases develop this will likely expand further. An important result of this renewed investment is that it has reaccelerated GDP growth to a 4.3% rate as of the 3rd quarter. It’s also driving an increase in market breadth, meaning more stocks are participating in the rally. Seeing more stocks rally is key as it takes pressure off tech stocks, thereby creating a more solid basis of support for the market overall.
On the flipside, a cooling labor market and rising consumer debt is a clear indication that the economy is uneven. A worker concerned about their job is likely to cut their spending and notably defer discretionary purchases. With the consumer representing 70% of GDP, this is likely why the Fed delivered a cut in December and has signaled a subtle shift from fighting inflation to supporting jobs. Interestingly, consumer spending also ticked up in the recent GDP report, indicating that so far behavior hasn’t shifted dramatically in aggregate. But part of this is because wealthier consumers are offsetting some of the softness seen in lower- and middle-income households. This dynamic may not be sustainable and so it will be a critical theme to watch.
Looking back, the positive factors outweighed the negative ones in 2025, with solid fundamentals giving investors reason to maintain exposure to growth areas of the market. At the same time, valuations continued to rise, leaving little room for disappointment should earnings growth moderate. This is particularly relevant to the question of whether all this AI spending will generate a sufficient return on investment, which is another emerging theme to watch. Rising debt and geopolitical tensions have also driven the buying of safe havens like gold, indicating a continued cautiousness amid the rally. For investors, this means greater selectivity going forward as prices and expectations have risen, with a renewed focus on the shifting winds of the market.
Fortunately, the leadership shift that started in the fourth quarter is a positive development and a continuation of this rotation may help the market sustain its gains. Already in the first few days of the year, a rally in energy and defense stocks on geopolitical developments have helped offset some continued profit-taking in Tech. Cyclicals like Industrials and Financials are likewise outperforming, which tends to happen when the economy is strengthening not weakening. These dynamics underscore the importance of maintaining a broadly diversified portfolio, so that when one part zigs another part zags. The AI stocks will remain top of mind given their importance to the overall market, but these developments are certainly a welcome shift.
Overall, while the path forward is not without challenges, we remain cautiously optimistic as we look forward into 2026. The economy and earnings environment remains resilient, with risk factors like the job market, debt levels, and geopolitics yet to cause too great a concern. As always, we will continue to monitor this evolving environment and maintain a steady hand amid market volatility. We stand ready to act when opportunities arise for portfolios. We thank you for your continued trust and wish you and your families well.