2Q Investment Commentary: Large-Cap Growth Stocks Lead
During the second quarter, the S&P 500 and NASDAQ reached new highs. Following a 15% drawdown in April, the market rebounded quickly, driven by tariff relief, earnings strength, and optimism surrounding artificial intelligence. The bounce back was quite extreme in some parts of the market; for example, the NASDAQ rose 35.1% from its low April 8.
This was a volatile period for financial markets, driven by rapidly changing policies. The returns of some of our public equity managers are a great example. At the end of the first quarter, respective returns for WCM International and Westfield Midcap Growth were off -0.2% and -9.5%, respectively, for the year. In 2Q, those strategies swung back wildly, returning 27.2% and 20.3%, respectively. These examples highlight the importance of sticking with an investment through volatile periods, a topic we addressed in our 1Q 2025 investment commentary. Had we exited Westfield and WCM after a short period of underperformance, we would have missed the rebound of two strategies now outperforming their peers in 2025.
Earnings need to broaden for equity markets to move higher
Large-cap growth stocks, primarily the AI megacaps, dominated returns in the quarter. However, returns broadened later in the quarter as feelings of uncertainty, consumer sentiment, and investors’ economic outlook improved. Value and small-cap stocks rebounded in May and June, and the other 493 stocks of the S&P 500, beyond the Magnificent 7, also reached new highs. This rebound is important because we believe that, for equities to move materially higher, earnings growth and equity returns need to broaden beyond the AI and megacap stocks.
Additionally, for us, CM Wealth portfolios are often overweight small-cap stocks. While we have delivered outperformance versus small-cap benchmarks, these benchmarks have underperformed large caps, which have weighed on equity returns. We continue to hold the view that these stocks are poised to deliver significant earnings growth as earnings growth broadens, more cyclical parts of the economy begin to normalize, and the benefits of automation and AI become more widespread. That said, as in the past, we are uncertain of that timing.
To highlight the earnings growth potential from small caps and less AI-centric parts of the market, we reviewed actual and estimated earnings over the past 18 months for large and small cap stocks. Heading into 2024, analysts forecast small-cap earnings growth of 24% versus large-cap earnings of 11%. Actual 2024 earnings growth was far off this pace for small caps at -17%, while 10% growth for large cap stocks was in line with expectations. For 2025, expectations for large and small cap earnings growth were 14% and 44%, respectively.
Those numbers have declined to 9% and 20.4%, respectively. We observe similar patterns, although not as pronounced, between the Magnificent 7 EPS growth forecasts and those from the other 493 stocks in the S&P 500.
To date, tech stocks have benefited from increasing investment in AI. We expect this trend to broaden, and that should benefit the broader equity market. Longer term, we believe that AI and automation can deliver a productivity boom that will have a broad impact across banks, insurance, industrials, and consumer products. Companies will not continue to invest in AI solutions unless they are beneficial to the business. For example, we have heard from an insurance company that it expects to save 20% of its claim costs over the next few years using AI and automation, a significant reduction that should directly contribute to profitability.
Outlook
Investor uncertainty declined throughout the second quarter, leading to an improved economic outlook and higher stock prices. The Trump administration backing down significantly from a draconian tariff policy was the most significant factor. Additionally, the Big Beautiful Bill is likely a near-term positive for the economy, so moves towards its ultimate passage in early July also helped in part.
We maintain our positive outlook on the economy and expect steady growth over the next few years. Steady labor markets and consumer demand continue to support the consensus view of a soft landing. While the uncertainty in the quarter was impactful, we understand that it has largely delayed capital expenditures and investments in growth, rather than canceling them. Critically, businesses are still planning for a growth-oriented environment rather than a recessionary one.
While these were positive factors during the quarter, tariff shocks and the long-term impacts of government debt could cause volatility in the markets. The administration still appears unsettled day-to-day on a tariff strategy, announcing new tariff levels on countries and subsequently delaying their implementation. The market has largely shrugged these off, but if some of these more draconian measures do go into effect, it could cause a selloff in the equity markets. Additionally, we expect inflation to return in the second half of 2025, with the impacts of tariffs starting to take effect. This should not present a significant economic problem if contained. Long-term tariffs may have some impacts the administration sees as positive; however, they create inefficiencies that will weigh on growth.
Lastly, we should mention government debt levels. Previously, we noted the negative impacts largely via inflation, from the massive ongoing fiscal and monetary stimulus post-COVID. Despite a healthy economy, the deficit spending continues. This leaves us increasingly concerned that rising fiscal deficits and high levels of government debt will create more volatile financial markets and weigh on long-term economic growth. The risks of a more significant economic shock rise with the increasing fiscal deficit. This topic deserves its own in-depth analysis, but the boiling frog is likely the most apt analogy. We do not know when or if we will cross a critical threshold with government debt, but the risks of a debt-caused crisis are rising.
For financial markets, we do not expect a perfectly smooth path in the second half of the year, but that is normal. Tariffs, geopolitics, Trump’s approach to dealing with the Fed, and a number of other factors could cause selloffs in stocks, but despite these concerns, we generally remain positive. We do believe we need to see broadening earnings growth. While part of analyst forecasts, the market has learned to discount it due to a number of false starts, as previously noted with small caps. If the broadening of earnings starts to materialize, we do expect it to drive stocks higher.
The views expressed are those of CM Wealth Advisors as of June 30, 2025, and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.