The markets have gotten off to a shaky start in 2025, as higher yields pose challenges for equity investors. The equity risk premium has created an obstacle for stocks. However, as we will explore in this piece, historical trends suggest further upside in equities remains likely. Market participants will need to navigate the headwinds posed by elevated yields, compounded by uncertainty around fiscal policy, geopolitical tensions, and ongoing economic challenges. With risks apparent, nimble and strategic investment approaches will be essential. This piece will examine the broader market backdrop, identify potentially advantageous areas for investment, and highlight the importance of the upcoming earnings season as a key factor in understanding sector dynamics and market sentiment heading into the year.

A Three year Rally?

The U.S. equity markets have delivered exceptional returns over the past two years, with the S&P 500 posting a 25% total return in 2024 following a 26% gain in 2023. This marks the first time the index has achieved consecutive years of returns above 20% since the late 1990s, during the dot-com boom of 1998 and 1999. While nearly half of 2024's performance came from just five mega-cap stocks—NVIDIA, Apple, Amazon, Alphabet, and Broadcom—the equal-weighted S&P 500 returned a still-impressive 13%, showcasing broader participation across sectors. The impressive run has raised concerns that equities can achieve a third year of gains. Historical patterns suggest more modest returns (8-10%) in the third year of a bull market.

Other indices have also performed strongly. The Dow Jones Industrial Average rose 17.4% year-to-date in 2024, reaching record highs near 45,000, while the Nasdaq Composite posted a robust 31% gain despite showing relative weakness since mid-year. Meanwhile, mid-cap and small-cap stocks have gained momentum, with the S&P 400 Mid-cap and Russell 2000 Small-cap indices advancing by 18% and 17%, respectively, year-to-date. Both indices recently hit significant technical milestones, with mid-caps setting all-time highs and small-caps nearing their November 2021 peak. As market leadership shifts toward SMID-cap stocks, investors are encouraged to add to positions on pullbacks, as these segments are expected to outperform in 2025.

S&P (ES continuous) 2024 Chart

The Importance of Breadth

Market breadth emerged as a significant concern for equity investors in 2024, especially in the latter half of the year. While the S&P 500 delivered an impressive total return of 25% for the year, nearly half of that performance was driven by just five mega-cap stocks: NVIDIA, Apple, Amazon, Alphabet, and Broadcom. The equal-weighted S&P 500, which provides a more balanced measure of performance across all constituents, returned a lower but still respectable 13%, highlighting the narrowness of the market's leadership. This divergence became particularly pronounced toward year-end, with the gap between the S&P 500's performance and the percentage of stocks trading above their 200-day moving average reaching rare extremes. December's market weakness, following a robust September-to-November rally, underscored these concerns, with the rally fueled by easing recession fears, the start of the Fed's cutting cycle, and favorable political developments giving way to a more uncertain environment.

Looking ahead to 2025, market breadth remains a critical factor. For the S&P 500 to sustain its upward trajectory and meet expectations of an 8-10% return, broader participation across sectors will be necessary. The breadth recovery likely hinges on several key drivers, including lower interest rates, a weaker dollar, and stronger earnings revisions. However, in the absence of these catalysts, the divergence between index performance and market breadth could persist, potentially resulting in a bifurcated year. The first half may face headwinds from policy uncertainty and lingering macroeconomic challenges, while equity-friendly policy measures, such as tax cut extensions or government efficiency reforms, could provide tailwinds in the latter half. The 2024 breadth environment serves as a reminder that, despite headline performance, sustained market health relies on more equitable participation across sectors and companies.

Watch those Bond Yields 

The rise in bond yields has become a critical issue for financial markets in early 2025, with the 10-year U.S. Treasury yield pushing decisively above the 4.50% threshold. This increase, driven by stronger economic data, higher inflation figures, and rising concerns over U.S. debt sustainability and fiscal policies, has reversed the previously positive correlation between equity and bond performance. Yields in the 4.00%-4.50% range were seen as a sweet spot for equity multiples, but the move above this level has created headwinds for stocks, narrowing market breadth and reducing valuations. Importantly, the term premium on long-term bonds has risen significantly—by 77 basis points since September—suggesting that investors are factoring in greater uncertainty around fiscal sustainability and the Federal Reserve's rate-cutting cycle. This dynamic has placed yields at the center of market attention, as their sustained rise could weigh further on equity performance and valuations.

10-Year Yield

Higher yields have divergent sectoral impacts, benefiting areas such as financials, which gain from improved lending margins, while pressuring rate-sensitive sectors like technology and utilities. Elevated yields also increase the equity risk premium (ERP), making stocks less attractive compared to bonds. This shift has contributed to a good news is bad news market dynamic, where stronger economic data raises fears of sticky inflation and tighter financial conditions, thereby pressuring equities. For equities to regain their footing amid higher yields, markets will likely need to see a more compelling case for economic growth (animal spirits) translating into stronger activity or evidence of moderating inflation. Until then, rising yields and inflationary pressures are likely to keep equities under strain, with the correlation between bond yields and stock performance remaining firmly negative.

Top Sectors in a Rising Rate Environment

Financials

• Why: Banks and other financial institutions benefit from higher net interest margins as they can charge more for loans than they pay on deposits.

• Key Players: Banks, insurance companies, and brokerage firms.

• Risks: Excessive rate increases can hurt loan demand.

Energy

• Why: Rising rates often coincide with economic growth, increasing demand for energy and driving higher commodity prices.

• Key Players: Oil and gas producers, pipelines, and energy equipment/services companies.

• Risks: Economic slowdowns can offset rate-driven demand.

Industrials

• Why: Economic expansion and infrastructure spending typically accompany rising rates, benefiting industrial companies.

• Key Players: Construction, machinery, aerospace, and logistics companies.

• Risks: Rising borrowing costs can affect companies with high capital expenditures.

Consumer Staples

• Why: Inflation often accompanies rising rates, allowing staple goods providers to pass on costs to consumers.

• Key Players: Food and beverage companies, household product manufacturers.

• Risks: Limited upside compared to growth-oriented sectors.

Real Estate Investment Trusts (REITs) – Selective

• Why: REITs in commercial and industrial real estate can benefit if economic growth drives higher rents, though rising rates can hurt financing costs.

• Key Players: Industrial and retail-focused REITs.

• Risks: Rising rates increase borrowing costs for leveraged real estate.

Top Sectors in a Falling Rate Environment

When rates are heading lower, sectors that are sensitive to borrowing costs and those relying on economic recovery tend to thrive:

Technology

• Why: Lower rates reduce the cost of capital, which is critical for growth-oriented tech companies with significant R&D investments.

• Key Players: Software, semiconductors, cloud computing, and high-growth tech firms.

• Risks: Overreliance on valuations driven by low rates.

Utilities

• Why: As defensive, dividend-paying stocks, utilities become more attractive when yields on fixed-income investments decline.

• Key Players: Electricity, water, and renewable energy utilities.

• Risks: Economic downturns can reduce industrial energy demand.

Real Estate Investment Trusts (REITs)

• Why: Lower rates reduce financing costs for real estate projects and make dividend yields more attractive relative to bonds.

• Key Players: Residential, office, and data center REITs.

• Risks: Overvaluation during prolonged low-rate periods.

Consumer Discretionary

• Why: Lower rates support consumer borrowing and spending, benefiting companies in this sector.

• Key Players: Retailers, automotive manufacturers, and leisure/hospitality companies.

• Risks: Limited spending capacity if the economy remains weak.

Health Care

• Why: Defensive growth stocks in health care become more appealing in lower-rate environments, especially when borrowing costs for biotech innovation decrease.

• Key Players: Pharmaceuticals, biotechnology, and medical device companies.

• Risks: Regulatory risks could offset benefits of lower rates.

Where Should I Invest in 2025?

As we enter 2025, market dynamics suggest exciting opportunities for investors, particularly in small- and mid-cap (SMID) stocks, alongside a continued emphasis on quality factors. After three years without reaching new highs, the Russell 2000 small-cap index is showing signs of a significant breakout, supported by a seismic leadership shift that began in July 2024. This trend underscores the potential for small caps to outperform larger counterparts in 2025, as broadening market breadth allows more sectors and stocks to participate in the rally. The technical evidence, coupled with the third year of this bull market, supports the case for expanding leadership, offering compelling opportunities for active portfolio managers to focus on leading stocks within top-performing sectors.

In this late-cycle environment, the quality factor remains a key focus, as companies with strong balance sheets and less leverage are better positioned to weather rising interest rates. Higher rates tend to pressure weaker, more leveraged businesses, making high-quality stocks particularly attractive. Additionally, industries such as software, financials, and media & entertainment, which are experiencing strong earnings-per-share (EPS) revisions, are expected to lead the market. This setup aligns with historical late-cycle dynamics, where larger-cap, high-quality stocks outperform. Still, the potential for SMID-cap leadership to further assert itself presents a unique opportunity for diversification and robust returns, as small- and mid-cap stocks often shine in periods of broadening market participation.

Looking ahead, the rise in the Russell 2000 and the expected shift in market breadth highlight the importance of strategic positioning. While the S&P 500 remains on track for a strong year, with a 2025 year-end consensus price objective of approximately 6,600, the real story lies in the opportunities within small and mid-caps. This widening breadth, combined with the resilience of high-quality sectors, sets the stage for active managers to excel by carefully selecting leaders in both SMID-cap and larger-cap spaces. With the market showing signs of transitioning into a more inclusive rally, 2025 offers a promising environment for disciplined, well-positioned portfolios.

Ways to Play the Small Caps

Here are four leading small-cap ETFs, notable for their significant trading volumes, assets under management (AUM), and focus on the small-cap segment of the U.S. equity market. Interestingly, all four ETFs share the same top holdings, which have contributed significantly to their performance over the past year.



Russell 2000  (RTY continuous) 2019-2024 Chart

1. iShares Russell 2000 ETF (IWM) 

This ETF tracks the Russell 2000 Index, which measures the performance of approximately 2,000 small-cap U.S. companies. Over the past year, IWM has delivered strong returns of approximately 15%, reflecting the resilience of smaller companies in the current market. Its top four holdings are Super Micro Computer, Inc., Chart Industries, Inc., Rambus Inc., and Lattice Semiconductor Corporation, each of which has seen impressive gains over the year, with some exceeding 20% returns.

2. iShares Core S&P Small-Cap ETF (IJR) 

IJR seeks to replicate the S&P SmallCap 600 Index, providing exposure to about 600 U.S. small-cap companies. The fund has returned around 13% over the past year, slightly underperforming its Russell 2000 counterpart. Its top holdings include Super Micro Computer, Inc., Chart Industries, Inc., Rambus Inc., and Lattice Semiconductor Corporation, which have collectively boosted the fund's performance thanks to strong growth across technology and industrial sectors.

3. Vanguard Small-Cap ETF (VB)  

This ETF tracks the CRSP US Small Cap Index, covering a wide array of small-cap stocks across multiple industries. VB has delivered a solid 14% return over the past year, benefiting from its diversified approach and strong contributions from its top holdings: Super Micro Computer, Inc., Chart Industries, Inc., Rambus Inc., and Lattice Semiconductor Corporation. These companies, particularly Super Micro Computer and Rambus, have been standout performers, driven by innovation and robust earnings growth.

4. Schwab U.S. Small-Cap ETF (SCHA) 

SCHA follows the Dow Jones U.S. Small-Cap Total Stock Market Index, offering broad exposure to small-cap U.S. equities. The ETF has gained approximately 12% over the past year, with its top holdings—Super Micro Computer, Inc., Chart Industries, Inc., Rambus Inc., and Lattice Semiconductor Corporation—acting as key contributors to its returns. These companies have capitalized on favorable industry trends, such as the increasing demand for technology and industrial innovation.

Each of these ETFs has benefited from the stellar performance of its top holdings, which have driven robust returns in 2024. With small caps showing potential for further upside, these ETFs provide investors with diversified exposure to this dynamic segment of the market.

Conclusion

As we look ahead to 2025, historical patterns provide a supportive backdrop for equity markets, with the S&P 500's two-year 20% rally suggesting another 8-10% upside potential. Additionally, the first year of a newly elected president often supports market gains, particularly in the second half of the year. However, challenges remain, as higher yields present a headwind to start the year, and uncertainty around fiscal and monetary policy has prompted investors to proceed with caution. Despite these concerns, technical indicators remain firmly bullish, creating a favorable environment for equities. Small caps, which historically perform well in the first year of presidential terms, present compelling opportunities, especially if market breadth improves. At the same time, stock pickers can find value in high-quality large-cap plays. While uncertainties persist, 2025 offers a promising setup for equity investors, supported by historical trends, technical strength, and sector-specific opportunities.