This Market Rotation Could Shock Investors in 2026

Key Concepts

Arms Race Mentality: Applied to the tech sector, particularly AI, where companies are aggressively investing in development and infrastructure, risking overspending and potential lack of widespread winners.
K-Shaped Economy: An economic pattern where higher-income households and larger companies perform well, while middle and lower-income households and smaller companies struggle, leading to divergent economic outcomes.
Fiscal Policy as a Headwind: The shift in government fiscal policy from a supportive role to a restrictive one, negatively impacting economic growth.
Circular Financing: A practice in the tech sector where companies lend money to each other to artificially inflate earnings and stock prices, potentially creating a bubble.
Risk Appetite: The willingness of investors to take on risk, which influences investment in speculative assets and growth stocks.
Labor Supply Constraints: Factors such as immigration changes that have reduced the available labor pool, impacting unemployment figures and hiring dynamics.
Tariffs and Trade Disruptions: Policies that increase the cost of imported goods, contributing to inflation and uncertainty for businesses.
Wealth Effect: The impact of changes in asset prices on consumer spending, where a significant decline in wealth can lead to reduced spending and economic slowdown.

Economic and Market Outlook

Current Market Sentiment and Rotation

The market has experienced a significant rotation away from highly speculative assets and companies with little to no earnings towards those with established earnings. This shift occurred from April to mid-October, with speculative assets like Bitcoin and certain equities peaking and subsequently pulling back. While the overall market (S&P 500) has seen a modest decline of 3-4% from its peak, speculative assets have experienced more substantial drops. This rotation is seen as a reflection of a weakening economic momentum and a "K-shaped" economic pattern, where higher-income segments are performing better than lower and middle-income segments.

Capital Flows and Asset Allocation

Capital is rotating within equities, moving into fixed income, and also flowing out of the US market into overseas equity markets. The US dollar, which was weaker earlier in the year, has stabilized recently. This indicates a repositioning between US and non-US assets, as well as within the equity market itself.

Key Macroeconomic Drivers for 2026

1. Corporate Earnings (Especially Tech Sector):

Key Point: Earnings reports, particularly for the tech sector, are crucial. Q3 earnings for major tech companies were largely positive, and earnings estimates continue to rise for the US.
Detail: This earnings tailwind is dependent on the continued strong performance of large tech companies.

2. Economic Mixed Picture:

Key Point: The overall economy is expected to present a mixed picture.
Detail: The unemployment rate is showing signs of creeping up, despite declining immigration and labor supply.

3. Federal Reserve Policy Constraints:

Key Point: The Federal Reserve is constrained in its policy response due to conflicting signals from inflation and the labor market.
Detail: Expectation of only one or two more rate cuts in the next six months, limiting stimulus potential.

Labor Market Analysis

Current Data and Trends:

Unemployment Claims: The number of Americans filing for unemployment benefits has been at its highest since early August, with over 1.9 million claims filed mid-October. For the week ending October 18th, 1.957 million people filed for unemployment insurance, with 232,000 new claims. This represents an increase of 10,000 from the previous week.
Weakening Trend: The labor market has continued to weaken, with weekly unemployment claims deteriorating somewhat over the last month.
Stasis, Not Crisis: The labor market is characterized by lower hiring but not widespread layoffs, creating a state of stasis. Labor supply has also decreased.
Unemployment Rate: The unemployment rate has risen to approximately 4.4%, indicating a gradual deterioration after strong readings in 2022-2024. This deterioration is attributed to weakening demand and labor supply constraints.
Conflicting Data (September Jobs Report): The September jobs report showed employers hiring more workers than expected (119,000 jobs added), defying the summer slowdown. However, this contrasts with the rising unemployment rate and increasing claims.
Non-Farm Payrolls Noise: Non-farm payrolls are considered a noisy data set, with prior months' figures being revised lower. This suggests fewer people are being hired, but also fewer are being fired, leading to a less dynamic but not yet dire labor market.
Impact of Labor Supply: The decline in labor supply makes the rise in the unemployment rate less severe than it would otherwise be. Economists are struggling to adjust for this significant shift in immigration and new labor supply.

Outlook on Layoffs:

Risk of Layoffs: There is a risk of increased layoffs into the new year and Q1 2026.
Mitigating Factors: Aggregate spending by consumers and businesses has held up, which generally supports labor demand and disincentivizes rapid layoffs.
AI Impact: The impact of AI replacing workers is considered potentially exaggerated in the short term and likely to be a gradual process.
Company Pauses: Many companies have paused projects outside of AI and tech due to policy and immigration uncertainty, waiting for clarity on the future.

Corporate Investment and Policy Uncertainty

Investment Trends: Corporate investment has been strong in tech (especially data centers) but is slowing down in most other sectors.
Drivers of Uncertainty: Uncertainty about policy, labor, and interest rates is hindering new investment in areas like factories and buildings.
Potential Catalysts for Investment: Rate cuts by the Fed, sustained consumer spending, and a rollback of policies like tariffs could encourage companies to proceed with paused plans.
International Impact: Companies considering international expansion or building factories overseas are on hold, awaiting policy clarity. A Supreme Court ruling against Trump's tariffs could provide some impetus.

Major Risks Facing the Economy

Fiscal Policy: The primary risk is identified as fiscal policy, including immigration, tariffs, and healthcare policy, which are seen as damaging to the US healthcare sector and contributing to labor market distress.
Tech Sector and AI: While the tech sector and AI are providing some support, they are not sufficient to maintain a strong labor market.
Asset Price Sensitivity: The economy is more sensitive to stock market and asset price movements than in previous years, due to increased exposure of individuals to markets through wealth and income. A significant stock market decline could have a greater economic impact.

Financial Sector and Credit Spreads

Financial Sector Health: The financial sector is generally considered sound. Earnings estimates for financials are holding up well.
Credit Concerns: Credit is not seen as a major problem for most of the economy, although some specific sectors and consumer credit are showing deterioration. Companies and households are generally not overleveraged.
Credit Spreads: Credit spreads are not expected to widen significantly in the near future.
AI-Related Debt: Concerns exist regarding AI-related data center debt, but overall credit conditions are viewed as decent.

Inflation and Federal Reserve Policy

Inflation Dynamics:

Trueflation vs. CPI: Trueflation, a private sector data source, is at 2.4%, lower than government CPI data.
CPI Trend: Government CPI data has been ticking up.
Drivers of Inflation:
- Shift from Services to Goods: Previously, services (including housing) were the main driver of inflation. Now, goods prices (appliances, imported items due to tariffs) are rising, while services inflation is slowing.
- Specific Factors: Health insurance costs, auto insurance, and other hard-to-measure factors are contributing to sticky inflation.
Fed's Concern: The Fed is worried about rising goods prices, which are directly linked to tariffs and trade disruptions. Companies may soon pass on these cost pressures to consumers.
Current Inflation Level: Inflation is around 3% or just under, above the Fed's 2.5% target.

Federal Reserve Policy:

Rate Cuts: The Fed has already cut rates twice this year. They are unlikely to cut again in December but may consider cuts early next year if the labor market weakens further.
International Central Banks: Other central banks have continued to cut rates throughout the year as inflation eases in their regions.
Fed's Stance: The Fed has indicated that tariff and policy uncertainty have prevented more aggressive rate cuts. They acknowledge the slowing labor market but are hesitant to cut aggressively with inflation still elevated.
FOMC Dissent: There has been unusual dissent within the Federal Open Market Committee (FOMC), with members advocating for both keeping rates high and cutting them more aggressively.
Trump's Influence: President Trump has publicly pressured the Fed to lower rates, even threatening to fire Fed Chair Jerome Powell. While Trump has appointed a board member (Steven Moran) who advocates for lower rates, he remains one of twelve FOMC members and has not been able to force the Fed's hand. Powell has stated he is not in a hurry to lower rates aggressively.

Tech Sector and the AI Bubble

Bubble Characteristics:

Capital Expenditure (CapEx): Significant CapEx in the AI space exhibits bubble-like characteristics, with a lot of extrapolation about future growth.
"Arms Race" Mentality: Companies are engaged in an "arms race" to develop the best AI models and capture market share. The risk is that not all participants will win, and in some cases, no one may win.
Nvidia's Role: Nvidia is currently the primary beneficiary, supplying chips to other companies for AI development.
Data Center Investment: Companies like Microsoft, Meta, and Google are investing heavily in data centers, citing customer demand for AI and cloud computing.
Return on Investment Uncertainty: The long-term return on investment for massive capital expenditures on data centers and chips is uncertain, especially given the rapid depreciation of technology.
Circular Financing: AI companies are reportedly engaging in circular financing, lending money to each other to prop up earnings and stock prices, which is a concern for market sustainability.

Investor Strategy in the Tech Sector:

Discerning Approach: Investors are advised to remain in equities and the tech sector but to be more discerning and differentiated.
Differentiation within Tech: Some areas within tech and communication services have started to lag (e.g., Meta, Netflix, T-Mobile), while others like Google, Apple, Microsoft, and Broadcom continue to perform well with rising earnings estimates.
Justified Multiples (to an extent): While some tech stocks appear expensive, they often have high margins, high Return on Equity (ROE), and continued revenue growth, which can partially justify their valuations.
Risk of Exiting Too Early: There is a risk of exiting the market too early, as leadership may persist in certain areas.
Fundamental Shift Needed: A fundamental shift in market conditions would be required to justify a complete exit from these tech areas.

Interest Rates and Presidential Influence

Presidential Pressure: President Trump has publicly expressed dissatisfaction with high interest rates and has pressured the Federal Reserve to lower them.
Treasury Secretary's Role: The Treasury Secretary cannot unilaterally lower interest rates, and the President does not hire or fire the Fed Chair.
Trump's Appointee: Trump appointed Jerome Powell as Fed Chair and recently appointed Steven Moran to the Fed board, who has advocated for lower rates.
Fed's Independence: Despite pressure, Jerome Powell has indicated no rush to aggressively lower rates, and market confidence could be damaged by an attempt to fire the Fed Chair.
Arguments for Lower Rates: While some argue for lower rates, the current unemployment rate (4.4%) is not historically high, and consumer spending is holding up. Aggressive rate cuts are not seen as necessary by many.
Political Posturing: The pressure from Trump is largely viewed as political posturing rather than a sound economic argument for immediate, aggressive rate cuts.

Consumer Sentiment and Spending Forecast

Weak Consumer Sentiment: Consumer sentiment has been notably weak, with the University of Michigan sentiment indicator at one of its lowest points in history.
K-Shaped Impact: This weakness reflects the K-shaped economy, where the majority of people may be experiencing stagnant or declining financial well-being, even if aggregate economic numbers appear stable.
Spending Drivers: While the average person's situation may be challenging, aggregate spending is still supported by higher-income individuals and larger companies.
Fed's Challenge: The Fed faces a challenge in managing the economy with blunt instruments like interest rates, which affect the economy with a lag and struggle to address the divergent impacts of the K-shaped economy.
Q1 2026 Forecast: Consumer spending is expected to continue struggling into Q1 2026, with the high-end segment holding up. Policy relief could improve the situation, but without it, struggles are likely to persist.
Rate Cut Limitations: The Fed will likely cut rates once or twice more, but high inflation (around 3%) and rising prices will make aggressive cuts difficult to justify.
Fiscal Policy Dominance: Fiscal policy is considered more impactful than monetary policy in influencing the economy, especially with a significant federal deficit still injecting money into the economy.

Asset Class Outlook

Stocks: Expected to hold up for a while longer.
Crude Oil Prices: Likely to struggle, remaining sideways to down due to weak supply-demand dynamics and ample supply. Refining margins may offer some support to refiners.
Bitcoin: Considered a measure of risk appetite. Its best move may be over, and it could take time to consolidate. It is not seen as a substitute for the US dollar.
Gold: May hold up due to continued demand to move assets and exposure out of the US dollar, especially while political uncertainty persists.
US Dollar: Demand to move assets out of the US dollar is expected to continue, driven by a desire for alternatives.
Euro and Other Non-US Currencies: Expected to benefit from the shift away from the US dollar.

Bitcoin vs. NASDAQ Correlation and Divergence

Historical Correlation: Bitcoin has historically shown a high correlation with stocks, particularly the NASDAQ, but with a much higher beta (volatility).
Recent Divergence: Since mid-October, while the NASDAQ has pulled back, Bitcoin has experienced a more amplified downward move.
Analysis of Divergence:
- Fundamentals: The NASDAQ represents companies with earnings and fundamentals, while Bitcoin lacks this structure.
- Risk Appetite: Both are influenced by risk appetite. The recent pullback in risk appetite has hit Bitcoin harder than the NASDAQ, which has earnings to provide some support.
- Speculative Assets: The most speculative tech stocks and those with no earnings have fallen the most, mirroring Bitcoin's decline.
- Market Phases: This pattern suggests a phase where highly speculative assets crack, while the broader market with earnings support may hold up longer, similar to past market cycles.
Risk of Economic Slowdown: The risk exists that a correction in equity markets could lead to reduced wealth for the affluent, decreased spending, and subsequently an economic slowdown. This is a greater concern now due to the increased reliance on asset prices and the wealth effect on a smaller segment of the population compared to previous years.

Conclusion and Where to Learn More

The current market environment is characterized by a rotation away from speculation towards earnings-driven assets, a mixed economic picture with a weakening labor market and sticky inflation, and significant policy uncertainty. The tech sector, particularly AI, exhibits "arms race" characteristics and potential bubble concerns due to aggressive investment and circular financing. Investors are advised to be selective within the tech space. Fiscal policy is seen as a greater risk than monetary policy, and the Federal Reserve faces constraints in its ability to stimulate the economy without exacerbating inflation. The demand for alternatives to the US dollar is expected to continue, benefiting assets like gold and non-US currencies.

For more information, visit Mil Street Research at Milstrearch.com. Sam Burns also posts updates on blue sky under the handle milstrearch. A blog subscription is available on the website for updates. Institutional investors can reach out for access to institutional research.

This Market Rotation Could Shock Investors in 2026 | Sam Burns