There's talk of a bubble in pockets of the stock market. And yet stocks — and equity mutual funds — shot higher anyway in the third quarter.
Wall Street bulls remain in charge. And why not?
In late September, investors finally got the interest-rate cut they've been hoping for. Corporate earnings are still on track for double-digit growth this year. And the economy remains resilient.
What's more, the AI trade, despite a growing chorus of warnings about overvaluation, is still working. And tariff fallout fears have yet to materialize in a big way.
Add it all up and you get a bullish backdrop for risk assets like stocks. And fund investors get fatter account balances.
Stock Market Keeps Rallying
The average U.S. diversified equity fund rallied 2.5% in September, ending the third quarter with a 7.2% gain, according to Lipper Refinitiv data. For the year, U.S. stock funds are up nearly 11%.
"It was a September to remember," said Adam Turnquist, chief technical strategist for LPL Financial.
As October gets underway, though, Wall Street has turned its attention to the first federal government shutdown since Washington closed for business for 35 days in December 2018 and January 2019.
There's also rising concern on Wall Street that the market is showing signs of overheating. The S&P 500's trailing 12-month P-E ratio of 25.9 is above the five-year average multiple of 23.3, the 10-year average of 21.6, and the average P-E multiple of 19.5 dating back to 1988, according to data from S&P Dow Jones Indices.
Funds Trail The Stock Market
Fund managers are having trouble keeping pace with the market benchmark's sizable gains. The returns of funds run by stock pickers this year trail S&P 500 index funds, which rose 3.6% last month, 8% in the July through September quarter and are up 14.5% on the year.
It was a broad advance for the stock market in the third quarter, with big-cap and small-cap stocks all participating.
Small-cap stocks, which benefit most from rate cuts, drove the stock market higher. The Russell 2000 small-cap index charged ahead 12% in the third quarter. That topped the tech stock-packed Nasdaq's 11.2% gain in the quarter. It was also better than the S&P 500's 7.8% quarterly gain and the Dow Jones Industrial Average's 5.2% third-quarter return.
Oren Shiran, manager of the Lazard US Systematic Small Cap Equity ETF, says "headwinds are decreasing and tailwinds are increasing" for small cap stocks. "There's an opportunity in small caps," said Shiran.
The bullish story centers on lower rates, cheap valuations relative to large caps, less exposure to tariffs due to small companies' domestic focus and solid earnings, says Shiran.
AI Stock Market Boom Continues
Tech stocks also continued to perform well amid the AI boom. Science and technology funds gained 7.3% in September and 11.2% in the third quarter, extending their 2025 gain to 21.11%.
A good deal of the heavy lifting for tech funds, such as the Invesco QQQ Trust (up 8.9% in the third quarter), came from the Magnificent Seven stocks. These megacap tech stocks, many of which benefit from the AI trade, accounted for two-thirds of the S&P 500's 3.7% total return in September, according to S&P Dow Jones Indices.
Talk of an overheated market, though, is glaring a spotlight on highfliers.
Lazard's Shiran said it's a mistake, though, to paint all companies and asset classes with the same brush.
"There's certain parts of the market where there's euphoria and valuations are very stretched, and, in those cases it's very likely that those do come down (in price)," said Shiran. He cites crypto, money-losing small company stocks and quantum computing stocks as examples of stretched areas of the market.
Growth Stocks Still Thrive
The AI trade, though, is being driven by fundamentals, Shiran says. Many of these companies generate a lot of revenue, have great profit margins, and are really great businesses, he says. "AI is not the story of the dot-com era when there was no revenue," Shiran said.
Growth funds are benefiting from investors' preference for companies with earnings momentum. Vanguard Growth Index ETF's 9.6% gain in the third quarter outpaced the Vanguard Value Index ETF's 6% advance.
Large-cap growth funds really took off in September, rising 4.1%, as investors cheered the Federal Reserve's first rate cut since December 2024. Midcap growth funds posted a smaller 0.9% gain last month and small-cap growth funds rose 1.7%.
The large-cap dominance over small caps is highlighted by the 15.2% year-to-date gain for large-cap growth stocks vs. a 6.1% 2025 gain for small-cap growth stocks.
Looking At The Sectors
Utility funds, which are getting a lift from the rising power demands of the AI buildout, jumped 4.1% in September, and were up 7.7% in the third quarter and 16.4% higher on the year.
David Laut, chief investment officer at Kerux Financial, believes stocks are vulnerable heading into the fourth quarter. "Valuations are stretched, and October is known to see elevated volatility," he said.
Still, Laut says he'll use pullbacks as an opportunity to strengthen his portfolio.
"We remain opportunistic during pullbacks and remind investors that pullbacks can be subtle and take place in small increments over several trading days," said Laut.
Checking In With Bond Funds
Despite the Fed cutting its key rate by a quarter point to a range of 4% to 4.25% on Sept. 17, longer-term bonds, whose prices are dictated by the market, didn't move much. The 10-year Treasury bond, for example, ended August yielding 4.23% and ended September at 4.152%.
Still, bond prices rose, and yields fell in response to the Fed's rate cut. That translated into gains for many types of bond funds.
IShares Core US Aggregate Bond, which invests in a diversified basket of investment grade bonds, gained 1.1% in September, 2% for the quarter, and is now up 6.1% for the year. Similarly, Vanguard Total Bond Market ETF rose 1.05% last month and 2% for the quarter, extending its year-to-date gain to 6.1%.
"The bond market still represents good value," said Warren Pierson, Co-CIO of Baird Advisors.
Going forward, Pierson sees the yield curve steepening. That means yields on the short end of the curve will head lower due to Fed easing. But rates on longer-term bonds could remain stubbornly high due to concerns about rising U.S. deficits.
So, where should bond investors put their money?
"Don't be too short and maybe don't be too long," Pierson said. "There is really good value in the middle."
The middle means intermediate bonds with durations of around five to seven years.
Scour The Globe For Gains
Stock investors with equity holdings overseas reaped rewards again. IShares Core MSCI EAFE, which invests in developed countries abroad, tacked on a 2.1% gain in September to extend its year-to-date gain to 26.5%.
World equity funds outpaced the S&P 500 in September, rising 3.3%. They were up 5.8% in the third quarter. World equity funds' year-to-date gain of 22.6% tops the S&P 500's gain by more than 11 percentage points.
The big world equity fund winner in the second quarter was China region funds. Unfazed by tariffs, these funds rose 7.6% in September and 21.2% in the third quarter, extending their year-to-date gain to a stellar 37.3%.
Looking ahead to October, the S&P 500 has historically posted a positive return 56.1% of the time, according to S&P Dow Jones Indices. In up months, the benchmark index has posted an average gain of 4.3%. In down Octobers, it has sunk 4.5%, on average. Its overall average performance in October, a month associated with stock market crashes, is a loss of 0.5%.
