2025's "Everything Rally": What Was Priced In and What Remains

The market narrative for 2025 was defined by a dramatic pivot. The year began with a sharp sell-off, as fears over U.S. tariff hikes to levels not seen since the 1930s rattled sentiment. Developed market equities fell 16.5% in early April, a clear warning of the cross-currents ahead. Yet by year-end, the story had flipped completely. A powerful "everything rally" drove all major asset classes to positive returns for the first time since the pandemic, delivering a 21.6% return for developed market equities and a 34.4% return for emerging markets.

This shift was powered by two key forces. For equities, the dominant theme was the AI investment cycle, supported by strong earnings, global easing, and fiscal stimulus. The communication services and information technology sectors led the charge, with returns of 33.0% and 23.6% respectively. Meanwhile, the standout performer across all asset classes was precious metals, which surged 80.2% over the year. This rally was fueled by central bank diversification, strong ETF inflows, and concerns over global fiscal expansion and policy uncertainty.

The sentiment swing reached its peak in late December. As the year closed, the market's mood flipped from the early-year pessimism to a state of extreme optimism. The S&P 500 set fresh records, and the Cboe Volatility Index (VIX) fell to its lowest level in over a year. This rapid transition-from tariff fears to record highs-captures the year's defining volatility and the market's remarkable ability to look past near-term storms.

The Expectations Gap: Forecasts vs. Reality

The market's 2025 performance created a stark gap between what was forecast and what actually happened. Major institutions projected modest returns, with Morgan Stanley and J.P. Morgan both forecasting the S&P 500 would finish near 6,500, implying a total return of just ~7-8%. The reality was a 17.72% total return, with the index closing near 6,845. This wasn't a minor miss; it was a fundamental miscalculation of the year's trajectory.

The core of this gap lies in the market's ability to "look through" significant turbulence. In April, the announcement of ultra-high "reciprocal" tariffs sparked a sharp selloff, a clear test of investor resolve. Yet, as the year progressed, the market digested this shock. Tariff threats were walked back, and the focus shifted to strong fundamentals. The AI investment cycle, supported by strong earnings and global easing, provided a powerful counter-narrative. This pivot allowed equities to not only recover but accelerate, delivering a nearly 39% total-return surge from the April low through year-end.

The consensus view, however, failed to anticipate this resilience. Forecasts assumed continued U.S. equity leadership, but international equities outperformed by a significant margin, with the MSCI ACWI ex-USA Index returning over 32%. This divergence suggests the models were anchored to outdated assumptions about market leadership. More broadly, the collective projection of ~10% global equity returns was well below the 21.09% actual return for the MSCI World Index.

The pattern here is telling. When the consensus consistently underestimates returns and misses major shifts in leadership, it often points to a market that has priced in perfection. The 2025 rally was built on a combination of policy reversals, unexpected earnings strength, and a global rotation into cheaper valuations. For this setup to repeat, the market would need to look through another set of significant headwinds with equal ease. That leaves little room for error. If the next quarter's data shows even a hint of softness in the AI-driven earnings growth or a resurgence of trade tensions, the current elevated sentiment could quickly unravel. The expectations gap of 2025 is a reminder that when the herd is wrong, it's often because the price already reflects a flawless outcome.

Valuation and the Risk/Reward Setup for 2026

Heading into 2026, the market finds itself in a precarious position. Despite the powerful rally, the underlying economic engine remains weak. Global growth projections are subdued, with advanced economies expected to grow around 1.5 percent. This creates a classic tension: asset prices have rallied on expectations of continued strength, while the fundamental data suggests a more modest expansion. The risk here is that the market's recent optimism is now priced for perfection, leaving it vulnerable to any stumble.

This sentiment shift is stark. In late December, the market's mood flipped from early-year pessimism to a state of extreme optimism, with the S&P 500 setting fresh records. This rapid swing-from tariff fears to record highs-is a historical warning sign. When sentiment indicators like the Daily Trading Sentiment Composite move into excessive optimism territory, it often signals a potential near-term decline. As one strategist noted, the S&P 500 averages a 4.93% annualized loss in such periods. While major peaks have often occurred at higher readings, the current level suggests the herd is fully committed, which can be a contrarian signal.

Against this backdrop, diversification is not just a good idea-it's a necessity. The 2025 rally was broad, but its drivers were specific: AI, strong earnings, and global easing. For 2026, with growth slowing and policy uncertainty lingering, investors should look beyond equities. Bonds, particularly in the U.S., offer a potential haven as the Federal Reserve's easing cycle continues. Meanwhile, precious metals have proven their value as a hedge against fiscal recklessness and policy instability, a role they played strongly in 2025. The key is to maintain a balanced portfolio that doesn't rely solely on the continued flawless execution of the AI investment cycle. The setup now is one of high expectations and low margin for error.

Catalysts and What to Watch in 2026

The market's current optimism is built on a fragile foundation. For the 2025 rally to hold, the underlying economy must deliver. The forward-looking test is whether global growth can sustain momentum above 3% as the temporary tailwinds of front-loading and stimulus fade. The latest projections show a clear slowdown, with global growth expected to decelerate to 3.1 percent in 2026. This creates a direct tension with asset prices, which have rallied on expectations of continued strength. If economic data begins to show a more pronounced deceleration, the market's ability to look past it could be tested.

A second major risk lies in the credit markets. The powerful "everything rally" has compressed risk premiums. Any escalation in trade policy or a sustained rise in default rates in high-yield credit could pressure historically tight spreads. The market has shrugged off significant trade tensions in the past, but the environment remains volatile. As noted, extremes of higher tariffs were tempered, thanks to subsequent deals and resets. Yet, prolonged uncertainty and more protectionism are listed as key downside risks. A resurgence of these pressures would directly challenge the risk-on sentiment that has driven the rally.

Finally, investors must monitor sentiment indicators for signs of a peak. Extreme optimism has historically preceded market corrections. The sentiment shift in late December was stark, with the Daily Trading Sentiment Composite swinging from extreme pessimism to extreme optimism in less than three weeks. While the current reading of 63.3 is below the levels of major market peaks, it sits in the "excessive optimism" zone. The AAII Investor Sentiment Survey provides a complementary view, showing bullish sentiment rising to 49.5% last week, well above its historical average. When the herd is this fully committed, it often leaves little room for error. A reversal in these sentiment gauges could be an early warning sign that the rally is losing its momentum.

The bottom line is that the current setup is one of high expectations and low margin for error. The market has priced in a flawless outcome. For the thesis to be validated, the economy must hold, trade tensions must remain contained, and sentiment must not peak too soon. Any stumble in these areas could quickly unravel the fragile optimism that has carried markets through 2025.