MARKET UPDATE [OCTOBER 2025]

MARKET OVERVIEW

October opened under intense macroeconomic uncertainty as the U.S. federal government entered a shutdown at 12:01 a.m. on October 1. With roughly 800,000 government workers furloughed, the shutdown immediately threatened consumer spending and federal services, and it also delayed critical economic releases including monthly jobs and inflation data, reducing market visibility and policymaker clarity. Historically, prolonged shutdowns drag GDP, and early analysis this month pointed toward similar risks, particularly given signs of softening labor-market momentum heading into the end of the year.

Labor data from alternative sources helped fill gaps left by the suspended federal reports. ADP reported a loss of 32,000 private payrolls, suggesting a slower hiring environment. Additional datasets signaled rising unemployment claims from federal employees and increased unemployment-benefit payments, indicating pressure on household income among furloughed workers. Broader business sentiment data echoed this weakness: U.S. manufacturing remained in contraction territory, with the ISM PMI holding below the 50 threshold, while services activity slipped to the breakeven line and business activity declined for the first time since 2020.

Despite the policy paralysis and macro uncertainty, U.S. equity markets displayed early resilience. Strong semiconductor leadership, optimism around AI-driven capital spending, and investor expectations for further Federal Reserve rate cuts supported risk appetite. Gold prices hovered near record highs on flight-to-safety hedging, though safe-haven demand eased briefly as hopes increased for a shutdown resolution and potential de-escalation in trade friction with China. Treasury yields trended modestly lower, consistent with historical patterns in which political gridlock raises recession concerns and drives defensive positioning.

Trade developments dominated market sentiment throughout the month. The White House raised tariff threats, including potential 100 percent levies on a broad set of Chinese imports and retaliatory measures targeting Canada. China responded with port fees on U.S. vessels, rare-earth export restrictions, and heightened antitrust scrutiny of American firms, intensifying supply-chain and geopolitical concerns. Headlines briefly drove volatility higher as investors reassessed global trade-flow risks, though sentiment stabilized later in the month as both sides signaled willingness to negotiate. Ultimately, the U.S. announced tariff reductions on selected Chinese goods in exchange for cooperation on fentanyl precursor controls and increases in agricultural purchases, with officials hinting that a formal agreement could be announced at an upcoming summit between President Trump and President Xi.

Corporate news contributed to a dynamic market backdrop. Earnings reports generally came in ahead of expectations. Several companies announced cost-reduction programs, workforce cuts, and share-repurchase plans to support profitability in a slow-growth environment. Semiconductor and AI-infrastructure demand accelerated meaningfully. ASML reported a surge in orders for advanced lithography tools. TSMC upgraded its full-year growth forecast, and NVIDIA became the first company to surpass a five-trillion-dollar market capitalization. Capital-investment announcements highlighted the scale of AI momentum, with multibillion-dollar infrastructure partnerships and initiatives unveiled by OpenAI, AMD, AWS, and other major technology firms. Traditional sectors were more mixed: automotive manufacturers faced weakening demand and tariff exposure, while aerospace and defense firms secured significant government contracts amid heightened global security spending.

Global macro data painted a varied picture. China reported 4.8 percent GDP growth in the third quarter, a rebound in industrial profits, and stronger-than-expected export performance, albeit with reduced shipments to the U.S. Europe continued to experience slowing inflation and weakening trade flows, with the EU export surplus narrowing notably. Canada saw falling home prices and reduced business confidence tied partly to cross-border tariff uncertainty. Meanwhile, Japan’s export recovery and South Korea’s solid GDP expansion underscored continued resilience across parts of Asia.

Cultural and scientific achievements also captured global attention. Nobel Prizes were awarded across medicine, physics, chemistry, and economics, with honors recognizing breakthroughs in immunology, quantum mechanics, and innovation theory — reminders of the continued pace of scientific and technological advancement despite geopolitical and economic uncertainty.

Financial markets experienced pockets of volatility as trade headlines and political events weighed on sentiment, but conditions stabilized into month-end on signs of policy cooperation and progress in U.S.–China discussions. The Federal Reserve reduced interest rates by 25 basis points, citing slowing labor data and inflation still near 3 percent, and emphasized a patient stance going forward. Equity markets recovered late in the month, buoyed by optimism surrounding trade talks and clarity on Fed policy. Despite economic softening, economists kept recession odds near one-third, but many modestly upgraded fourth-quarter GDP expectations, supported by accelerating AI capital investment and declining trade-policy uncertainty.

MANAGEMENT DISCUSSION & ANALYSIS

A.    Key Changes to Fundamental Drivers of Market Growth and Risk

S&P500 Market Cap (October → November): 56.295 trillion → 58.210 trillion

Analyst Consensus Earnings Forecasts (2025): 267.9 → 267.4

Analyst Consensus Earnings Forecasts (2026): 304.9  → 305.0

Model Earnings CAGR:  9.23%  → 9.20%

S&P500 Aggregate Earnings (TTM) latest quarter (in $ Billions): 487.33  → unchanged 

06/30/2025 Preliminary Earnings (in $ Billions): 545.91 → unchanged 

S&P500 Aggregate Dividends (TTM) latest quarter (in $ Billions): 164.1 → unchanged 

06/30/2025 Preliminary Dividends (in $ Billions): 165.16 → unchanged 

S&P500 Aggregate Buybacks (TTM) latest quarter (in $ Billions): 293.45 → unchanged 

06/30/2025 Preliminary Buybacks (in $ Billions): 234.57→ unchanged 

Model Payout Ratio %: 82.15% → 80.51% → unchanged 

B.    Implied Equity Risk Premium

The implied equity risk premium (IERP) represents the excess return investors demand for holding equities instead of risk-free government bond. As it is not directly observable, the IERP is estimated by discounting expected future cashflows, primarily aggregating dividends and share repurchases. At Baoro Research, we calculate the IERP each month at the market index level, utilizing it as an indicator of valuation conditions, investor sentiment, and consequently, potential market direction. As of September 30, 2025, our estimate for the IERP stands at 3.85%, which remains notably below both the historical average of approximately 5.36% and the recessionary threshold of 6.16%.

C.    Market Valuations

Using an average equity risk premium of 5.36%, the updated implied fair value of the S&P 500 stands at 4,906.17, compared to the prior estimate of 4,887.48. This upward revision primarily reflects the Federal Reserve’s rate cut and an associated rise in demand for long-duration U.S. Treasuries amid heightened safety-seeking behavior.

Despite the non-revised aggregate repurchase amount by S&P500 firms in aggregate, risks of such large buybacks during an extended market valuation has to be restated as per our analysis that we made in the previous month-end report.

1.      Misallocation of capital

Buybacks are most value accretive when stocks are undervalued If companies repurchase heavily at inflated valuations, they destroy long term shareholder value by paying too much for their own equity instead of investing in productive growth. This is similar to buying back “high” and then later needing to reissue equity at “low”, which may result in a net loss for various firms.

2.      Vulnerability in downturns

When markets correct, those expensive buybacks leave companies with less cash and as a result more inherent financial leverage, which is especially pronounced if firms have engaged in additional borrowing to fund repurchases. This can inherently increase financial fragility, especially in firms with greater cyclical nature to their business model.

Taking these considerations into account, the following table presents S&P 500 index valuations across a range of key implied equity risk premium (IERP) levels.

S&P500 Value (IERP 6.16%)

An IERP of 6.16% is commonly observed during periods of economic downturns, which for value investors can indicate a suitable moment to reintroduce equity risk into portfolios. Should the current market narrative lead to challenging economic conditions, S&P500 valuations suggest prices could decrease to 4260.39, a 60.75% decline from current levels. Despite the extent of this potential overvaluation, this remains the base case model, with the intention to reintroduce equity exposure if such a scenario unfolds.

S&P500 Value (IERP 6.93%)

An IERP of 6.93% is typically observed during periods of substantial market decline, such as at the height of the global financial crisis. Should a similar scenario arise, the index could experience further depreciation, with the S&P 500 potentially reaching 3,779.86, which would be a decline of approximately 81.18%. While this extent of price decrease may appear improbable, it remains within the realm of possibility based on historical precedents. For instance, equity markets dropped 89% from peak to trough during the Great Depression (1929 to 1932), while during the dotcom bust and subsequent financial crisis, the Nasdaq Composite fell roughly 78% from its March 2000 high to its October 2002 low. Similarly, the S&P 500 and Dow Jones Industrial Average both declined by approximately 50 to 57% during the 2007 to 2009 financial crisis.

Multiples Lens

Due to variability in the inputs and outputs associated with the IERP model, a multiples-based valuation is also conducted. In this approach, cash flows are represented by the sum of aggregate S&P500 firms’ dividends and buybacks on a trailing twelve-month basis.

Data from our model indicates that the S&P 500 historically has an average price to cash flow ratio of 23.4. The multiples at plus or minus one standard deviation are 28.4 and 18.4, while the values at plus or minus two standard deviations are 33.4 and 13.3. Using the most recent trailing twelve months aggregation of firm dividends and buybacks, the following valuations are derived across these key multiples.

Valuation Summary

D.    October Bottom Up IERP

The Implied Equity Risk Premium (“IERP”) is commonly estimated using methodologies similar to the internal rate of return in project finance or the yield to maturity of a fixed income instrument. At the aggregate market level, the IERP is understood as a market capitalization weighted average of the IERPs of the individual securities that comprise the index. This framework permits the cross validation of top down IERP estimates by reference to bottom up calculations performed at the security level.

Our bottom up estimation process, conducted on a monthly basis, entails valuing individual securities using cash flow measures deemed appropriate under the circumstances, which may consist of dividends only, dividends together with share repurchases, or free cash flow to equity. Long term median regression betas are employed as the primary measure of systematic risk. It should be noted that these estimates do not incorporate adjustments for country risk premiums or for other categories of risk premium, including small capitalization risk premiums.

In light of the limited incremental benefit associated with valuing all 500 plus constituents of the S&P 500 Index, we calculate IERPs directly for those securities that, in the aggregate, represent 81.60 percent of the index’s total market capitalization, equivalent to 138 of the 503 constituents. The implied premiums for the remaining securities are extrapolated by reference to the median IERP derived from the directly calculated sample.

As of October 2, our bottom up methodology yields an IERP estimate of 3.19 percent. This reflects a material decline from the 3.79 percent estimate reported in July. Such a decrease indicates that investors are presently requiring a reduced premium over the risk free rate to hold equities, a condition that may reasonably be interpreted as evidence of elevated equity valuations relative to fixed income securities.

E.    Recession Probability

The New York Federal Reserve publishes recession probability estimates based on treasury spreads, particularly the difference between the 10-year bond rate and the 3-month treasury bond yields. According to these measures, the projected recession probability for September 2026 is 27.42%, which is lower than the approximately 70% estimate reported in early 2023 during a period of heightened market inflation concerns.

F.    Canary 

Consumer Discretionary: Overvalued by 19.54%

Consumer Staples: Overvalued by 0.17%

Energy: Overvalued by 24.97%

Financials: Overvalued by 31.54% 

Healthcare: Overvalued by 4.04%

Industrials: Overvalued by 31.74% 

Basic Materials: Overvalued by 10.10% 

Technology: Overvalued by 30.48% 

Utilities: Overvalued by 14.21%

G.    Value Screen Results 

Each month, we conduct fundamental screening and valuation across a universe of 11,505 U.S listed companies that meet our criteria. This month, 81 companies were screened, of which 6 companies were identified as undervalued.

1.      The Clorox Company

2.      Gilead Sciences

3.      The Hershey Company

4.      Kimberly-Clark Corporation

5.      Altria Group

6.      Merck & Co, Inc.

CLOSING REMARKS

With the equity risk premium continuing to trend lower, we believe downside risks have risen substantially while the potential for further upside has diminished. Throughout most of fiscal year 2025, our view has been that the implied equity risk premium would exhibit mean reversion, particularly given already stretched market valuations and elevated uncertainty across fiscal and monetary policy. In addition, the U.S. tariff framework and broader geopolitical tensions were expected to reinforce this mean reversion dynamic.

Despite these factors, equity markets have continued to climb, supported by strong investment spending, especially in data center infrastructure tied to AI-driven demand, and renewed momentum in domestic manufacturing capacity. Optimism around these themes, combined with ongoing Fed funds rate cuts and the resulting easing in financial conditions, has pushed valuations higher and driven the equity risk premium lower. In our view, market behavior now increasingly reflects characteristics consistent with a nascent bubble environment.

The chart below reinforces our concern. It plots year-end equity risk premiums and S&P 500 price-to-earnings ratios back to 1960, with the primary axis showing the risk premium and the secondary axis showing P/E multiples. The current risk premium sits at a critical inflection point, from which it could either compress further or reverse sharply higher. While long-term valuation history and mean-reversion patterns suggest caution, it is also clear that markets have previously sustained extended periods of elevated valuations.

A common argument against the idea that the current market environment represents a bubble rests on comparisons to the early 2000s. While valuation levels today appear elevated and in some cases resemble periods like 2000 to 2001, the underlying fundamentals of leading companies are materially different. During the dot-com era, many technology firms with limited or no profitability traded at extremely high sales multiples, and leading firms such as Cisco at the time traded at earnings multiples exceeding 200 times. In contrast, companies at the center of today’s AI-driven cycle, such as Nvidia, trade at significantly lower valuation levels, often at a fraction of those seen in the earlier bubble period. These companies also exhibit strong and consistent revenue and earnings growth, supporting their valuation levels. This characteristic is shared broadly across other major leaders in the current market, often referred to as the “Magnificent Seven.”

Looking at our dataset, one key feature historically associated with bubble environments is the implied equity risk premium compressing toward the 2.5 percent to 3.0 percent range. With this historical reference in mind, a central question becomes how much further valuations on the S&P 500 may be able to stretch if risk premiums continue to trend lower and the current momentum persists.

S&P500 Valuation (IERP 3.0%)

Based on our S&P 500 market valuation model, we estimate that when the implied equity risk premium reaches 3.0 percent, a fair market value for the index would be approximately 8,817.60. This corresponds to a price-to-earnings ratio of 36.58 and implies potential upside of roughly 22.43 percent from current levels, using the most recent observations of cash flows and earnings.

S&P500 Valuation (IERP 2.5%)

If however, the equity risk premium is lower only by 50 basis points more than our previous scenario, we get an S&P500 intrinsic valuation of 10,595 or S&P500 price earnings multiple of 43.95, implying an upside of 35.44% from current levels.

Despite the seemingly mixed signals, one point remains clear: the risk-reward profile is increasingly tilted to the downside. In our view, protecting against downside risk is critically important in the current market environment. If doing so requires sacrificing some near-term upside, we believe that is a prudent trade-off. Over the long run, markets tend to converge toward their fundamental values, and maintaining discipline through periods of elevated risk is essential to preserving capital and compounding returns.

Consistent with this philosophy, we will continue to emphasize downside protection through targeted hedging strategies, while remaining invested in high-quality businesses with strong fundamentals and durable catalysts that align with our investment framework.