Stocks have a pretty good backdrop for 2026, says Piper Sandler's Michael Kantrowitz

Key Concepts

• AI Extell: A term used to describe the current market focus on Artificial Intelligence.
• Inflation Anxiety: A state of heightened concern about rising prices.
• Labor Market Softening: A trend of decreasing employment growth or increasing unemployment.
• PE Expansion: An increase in the price-to-earnings ratio of stocks, indicating investors are willing to pay more for each dollar of earnings.
• Russell 2000: A stock market index that represents small-cap U.S. companies.
• ISM (Institute for Supply Management) Index: A monthly survey that measures the economic health of the manufacturing and services sectors.
• Yield Curve: A graph that plots the yields of bonds with differing maturities.
• Fiscal Policy: Government actions related to spending and taxation.

Market Outlook and Investment Strategy

Michael Kantrowitz, Chief Investment Strategist at Piper Sandler, presents a bullish outlook for the market extending into 2026, emphasizing a focus on fundamental economic indicators such as housing, orders, profits, and employment. He argues that the market's current rally, while strong, is not solely driven by AI earnings but also by a significant expansion in price-to-earnings (PE) multiples, a phenomenon linked to declining inflation.

The Shift from Inflation Anxiety to Labor Market Softening

Kantrowitz posits that the market's primary concern has shifted from inflation in 2022-2023 to the softening of the labor market in recent years. He draws a parallel to historical inflationary episodes where elevated inflation anxiety was a dominant theme. His core argument is that a softening labor market, coupled with Federal Reserve rate cuts, signals a transition out of a bear market and the potential beginning of a broader economic rally.

• Historical Context: Kantrowitz advises investors to look back at periods of high inflation anxiety.
• Current Scenario: He observes a softening employment landscape, which he believes will lead to lower interest rates.
• Market Correlation: The market is currently exhibiting an inverse correlation with equities and interest rates, which has been a positive driver.
• Broadening the Market: Lower rates are seen as crucial for manufacturing, transportation, and housing to improve and contribute to a stronger economic backdrop in 2026.

Reinterpreting the Current Rally

Kantrowitz addresses concerns about the market's strength, suggesting that the rally needs to be compartmentalized. He notes that the period from 2023 to 2025 was largely about recouping losses from the 2022 bear market, which saw significant declines in pieces and widening credit spreads.

• AI and Large Caps: The rally was initially driven by AI earnings, benefiting large-cap and growth stocks.
• Russell 2000 Performance: The Russell 2000 index, representing small-cap companies, has returned to its highs, but this is attributed to PE expansion rather than earnings growth.
• PE Expansion Driver: The decline in inflation is identified as the primary catalyst for this PE expansion.

The "No Pain, No Gain" Scenario in the Labor Market

Kantrowitz highlights the "no pain, no gain" aspect of the current economic situation, particularly concerning the labor market. He acknowledges that while employment is softening, this is a necessary precursor to lower interest rates.

• COVID-19 Hiring Surge: The pandemic saw a massive surge in hiring, with companies like Amazon doubling their workforce.
• Labor Market Reset: Current layoffs, such as those at Amazon (14,000 jobs), are viewed as a "labor market reset" and a normalization from the pandemic-induced hiring spree, rather than a sign of a deep recession.
• Distinguishing Layoffs: Kantrowitz differentiates between margin-pressure-induced layoffs and those related to AI, COVID normalization, and cyclical components in smaller businesses. He expects this sluggishness in the labor market to persist into 2026.

Forward-Looking Indicators and the Path to Expansion

Despite the current weakness, Kantrowitz remains optimistic about the future, pointing to forward-looking indicators that suggest a return to expansion in 2026.

• ISM Index: While still weak, the ISM index has been hovering around levels that, according to forward-looking indicators, will eventually lead to expansion.
• Key Forward-Looking Signals: These signals include changes in interest rates, oil prices, money supply growth, and the yield curve.
• Fiscal Policy Impact: The anticipated fiscal policy measures in 2026, potentially adding half a percentage point to GDP, are considered additional positive factors.
• Rate Stabilization: The stabilization of interest rates after peaking in 2023 and the Fed's ongoing rate cuts are seen as crucial drivers for future economic improvement.

Conclusion

Michael Kantrowitz's analysis suggests a bullish market outlook for 2026, driven by a shift in focus from inflation to a softening labor market. He argues that this labor market reset, while seemingly negative, is a necessary condition for lower interest rates and a subsequent broadening of the economic rally. The current market strength is attributed to PE expansion fueled by declining inflation, and forward-looking indicators point towards a return to economic expansion in 2026, further bolstered by fiscal policy.