Small Company Returns Take the Spotlight
I hope you are enjoying the cooler fall months and looking forward to the holiday season.
During the third quarter of 2025, the S&P 500 Index gained 7.8%, the NASDAQ Index gained 11.2%, the Russell 2000 Growth Index gained 12.0%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) gained 0.7%.[1]
As one can see from the last quarterly return, the smaller company index, the Russell 2000 Growth Index, beat the NASDAQ. The NASDAQ index includes many of the “Mega-Tech” and AI (artificial intelligence) names. Here are a few possible reasons to explain the small company index outperformance.
- Continued earnings growth among these small, underfollowed names.
- More balanced sector distribution than the high concentrations of Mega-Tech/AI S&P 500 and NASDAQ indexes.
- More resilient economy than most analysts expected.
- A possible change in mood of investment committee allocations.
In the past quarter, there was more talk that the Mega-Tech and AI companies, like Nvidia, Microsoft, Apple, Google, and Amazon have become too expensive in relation to their current and future earnings prospects. From my perspective, their share prices reflect a ‘Goldilocks scenario of analysts’ 5-year growth projections unfolding perfectly.
Looking back at the past five years, could you 100% predict what will happen in the next 5 years? Probably not.
This is where investors and stock prices run into a stumbling block. Stock prices are determined by many variables, but are highly weighted towards current and future earnings trends, interest rates, and investors’ sentiment. Many analysts estimate a stock’s price target by forecasting its earnings for each future year, discounting those earnings based on expected interest rates, summing the discounted values, and then adjusting the total to reflect the anticipated investor sentiment toward the stock.
This is very subjective, not objective. Over five years, are the prices of Van Gogh or Dali paintings going to rise or fall? What will the appetite of art collectors look like? And, to what magnitude and when will this happen?
Today, AI stocks, much like the internet stocks of the late 90’s, are in a situation of investors beginning to feel these high-flying stocks may be in a bubble from overly aggressive predictions by analysts and overly positive investor sentiment about the future. If today’s tech market crashes like it did during the Dot-com bubble in the early 2000s, there’s an important difference; many of today’s companies are making money and have cash reserves. Back then, most internet startups were losing money and burning cash, which made the crash much harder on them.
During a market rout, the stock hype premium disappears, and new stock prices need to be calculated. A reasonable value judgement can be made, albeit lower, for a company with earnings and cash. Companies with negative earnings and burning cash can drop to a near zero valuation very quickly since their value is hype and speculation.
As in my last quarterly letter, I believe a market correction is coming, but it will offer an opportunity for investors to buy. The economy has been resilient and there continues to be over $7 trillion in money market funds of which some portion could be enticed by lower stock prices and provides somewhat of a safety net for the stock market.
Market participants continue to monitor the ongoing tariff situation and are keenly aware of the US dollar weakness, the rise in commodities such as gold, the Fed interest rate policy, and the government shutdown. These variables are tied together and complicated to unweave. In addition, each movement has a positive and a negative implication, but the speed and magnitude of a change can’t be predicted accurately.
To give you a feeling of the size of financial markets and their importance, here are some recent estimates:
- Currency: The global foreign exchange (forex) market boasts a staggering total value of $3.5 quadrillion, with $9.6 trillion traded daily.
- Global Bonds: Total market value stands at $145.1 trillion, including $28.6 trillion in U.S. Treasury securities.
- Global Stocks: The total market capitalization of global equities stands at $126.7 trillion.
In my experience, interest rates are the linchpin of the financial puzzle; their fluctuations can ripple through the much larger currency market, prompting governments, major banks, and insurance firms to reposition assets in response.
Since the markets are global, currency plays a key role in international financial operations. It facilitates global business transactions, enables investments across borders, and plays a key role in determining the relative value of world currencies.
Interest rate changes also affect the cost of government, company, and home borrowings, as well as auto purchases. It also may signal that the Fed is worried about a weak labor market and lower future economic activity. Typically, an interest rate change will be the catalyst to send the ball rolling through the currency, bond, and stock market.
Because of the importance of the interest rate changes and the size of the currency market, the largest institutional investors closely monitor central bank interest rate moves and commentary to develop their bond and lastly, stock allocations.
The following is a small glimpse into one aspect of this very complicated situation.
Over the past year, the expected Federal Funds target rate range has been declining, and until recently, the U.S. dollar had been weakening. Lower rates and dollar value make U.S. assets less attractive to foreign investors. Financial entities and countries are wary of holding an asset based on a currency that is dropping in value. Here, it makes servicing the U.S. debt much more difficult and could mean higher taxes and money printing to cover the deficit. Inflation would likely rise significantly, and the economy would materially get hit.
Promoting or allowing this scenario to develop is called Inflating the Debt Away. A strategy in which a government generates inflation to reduce the real value of its outstanding debt, making it easier to repay. It can be a very dangerous proposition if the lower rates do not spur the economy in time to produce the economic benefit to cover the debt service.
Gold has been soaring during this period, as it has many functions and moves counter to the dollar it’s traded in. It is a safe haven asset and gains popularity in times of uncertainty. In August alone, central banks continued their gold purchases to the tune of 19 metric tons, as fiat currencies around the globe are deemed riskier as debt soars. Some exposure to hard assets on a pullback is likely warranted.
The Government shutdown is certainly not a benefit to the economy and creates added uncertainty. The markets are driven by information with many statistics coming from government agencies. With a delay in reporting, it puts financial decision making at a standstill since the statistics are needed to support decisions. The shutdown could also produce a drag on GDP as U.S. government expenditures are 36.3% of GDP. Before making financial decisions in this uncertain environment, be sure to realize how a transaction may be affected. In the near-term there may be pain in some areas, and then a rebound. In the long-term, it will most likely be remembered as another ugly political rift.
On the tariff front, deals have been initiated with the EU and Japan in July, relieving some uncertainty, but China continues to retaliate against settling the trade dispute. China is the 800 lb. gorilla in the room on this one due to their vast retail production and rare mineral exports. This could significantly hinder the performance of certain companies if the dispute is not resolved before stockpiles are diminished. I believe China has more to lose in the near term from internal unrest and is posturing for a bargaining advantage in the late October meeting between Trump and China’s Xi in South Korea. I’m taking a wait and see attitude before making a decision on companies in this area.
Very truly yours,
Martin L. Yokosawa
Torii® Asset Management, Inc. Landolt Securities, Inc.
Copyright Martin L. Yokosawa. All Rights Reserved
Securities processed by and investment advice provided through Landolt Securities, Inc. Member: FINRA/SIPC
Torii Asset Management, Inc. and Landolt Securities, Inc. are not affiliated companies.
DISCLAIMER.
This presentation was created by the research and thoughts of a human, not by an artificial intelligence (AI) program that generates content automatically. AI can produce text, images, or presentations based on prompts, often mimicking human writing style, but lacking the nuanced understanding and creativity of a human author.
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[1] These returns are price based and exclusive of dividend reinvestment. Return data provided by QUODD Financial, ETFreplay.com, and Yahoo Finance