Why the bull market could continue through 2026 (and why it could end)

Key Concepts

• Year-End Target: A projected market level for the end of the current calendar year.
• Earnings Growth: The increase in a company's profit over a period.
• Bifurcated Market: A market where different sectors or types of stocks are performing very differently.
• Valuations: The assessment of a company's worth, often expressed as a price-to-earnings (P/E) ratio.
• P/E Multiples: The ratio of a company's share price to its earnings per share.
• Growth Index Fund: An investment fund that focuses on companies expected to grow at an above-average rate.
• Mag 7: Refers to the seven largest technology companies in the S&P 500 (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta Platforms, and Tesla).
• K-Shaped Economy/Market: An economy or market where different segments are diverging significantly in their performance, with some doing very well and others struggling.
• AI (Artificial Intelligence): A broad field of computer science focused on creating intelligent machines that can perform tasks that typically require human intelligence.
• Capex (Capital Expenditures): Funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, and equipment.
• Put Options: A contract that gives the owner the right, but not the obligation, to sell an asset at a specified price on or before a certain date.
• Barbell Strategy: An investment strategy that involves holding both very safe and very risky assets, with little in between.
• Nominal GDP: The gross domestic product of a country measured in current prices, without adjusting for inflation.
• Free Cash Flow (FCF): The cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
• Private Credit Markets: Debt financing provided by non-bank lenders to companies.
• Teflon Market: A market that seems resistant to negative news or events, with prices continuing to rise.
• Fiscal Tailwinds: Government policies or spending that support economic growth.
• Core PCE (Personal Consumption Expenditures): A measure of inflation that excludes volatile food and energy prices.
• Neutral Rate: The theoretical interest rate that neither stimulates nor restrains the economy.
• Hyperscalers: Large cloud computing providers that can scale their infrastructure to meet massive demand.
• ROI (Return on Investment): A performance measure used to evaluate the efficiency of an investment or compare the efficiency of a number of different investments.

Market Outlook and Earnings

The discussion begins with a focus on the year-end target for the S&P 500, estimated to be around 7050, implying a 3-4% rally from current levels. However, the primary focus shifts to the outlook for the next 14 months, with earnings identified as the key catalyst. The market anticipates a double-digit earnings growth year, around 13-14%, which is expected to drive healthy returns even if these numbers are slightly lighter.

Despite macroeconomic headwinds like government shutdowns and tariffs, earnings have held up remarkably well. This strength is largely attributed to the tech and AI trade.

Earnings Bifurcation

A significant point highlighted is the bifurcation in earnings growth:

• Tech companies are experiencing year-over-year growth of approximately 27-28%.
• Financials are showing a 23-24% growth rate, partly driven by M&A and deal activity, representing about half of the S&P 500's overall earnings.
• Traditional cyclical groups (industrials, discretionary, energy, staples) are delivering much weaker growth, around 2-4%.

Earnings Season Strength

The health of earnings season is further underscored by companies beating expectations by an average of 9%, which is considered an "insanely strong number" compared to the typical 4-5% beat. Revenue (top-line) beats are at 2%, which is also stronger than usual. This surprise strength is observed across almost every sector, despite the growth rate disparities.

Valuations and Market Concentration

A key debate revolves around whether the market's rise is driven by speculation and excessive valuations, particularly in certain areas.

Earnings vs. Valuation Driven Gains

It's argued that investors often mistake market rallies for increased valuations. For instance, tech companies are up around 26-27% year-to-date, with approximately 22% of that attributed to earnings growth, leaving a smaller portion for valuation increases. The overall market's higher P/E ratio is seen as a "mix issue" due to the increasing weight of tech and high-P/E stocks, rather than individual companies having problematic P/E multiples. In fact, larger tech companies' P/E multiples are noted to be lower today than two years ago.

Concentration Risk and the "Mag 7"

The market's performance is heavily influenced by a few dominant companies, often referred to as the "Mag 7." These companies are driving a significant portion of the S&P 500's gains and earnings. While this concentration is acknowledged, it's contrasted with the late 1990s bubble, emphasizing that current gains are driven by real companies generating real revenues and profits, often capacity-constrained.

Overweighting Growth Sectors

The discussion suggests that buying the broad S&P 500 inherently means overweighting tech. A strong argument is made for focusing on growth index funds or mutual funds, which have historically outperformed the broad S&P 500. The "American exceptionalism" is seen to reside in the tech sector, with potential in healthcare and biotech. The non-tech portion of the S&P 500 is seen as performing similarly to the rest of the world.

Risks and Potential Slowdowns

Despite the optimistic outlook, potential risks are identified:

Economic Slowdown and Tariffs

While economists expected tariffs to have a significant impact, their effect has been minimal so far. However, there's a possibility that the impact is delayed, leading to a weaker economy. A rise in the unemployment rate could cause companies to cut back on spending. The labor market is described as "tepid," with a disconnect between a strong market and weaker job growth.

Funding of Tech Endeavors

A concern is raised about the "Mag 7" players funding their endeavors through debt markets rather than cash flow. While companies have strong balance sheets and are attempting to lever responsibly, the risk of intertwined funders and companies becoming "too big to fail" is being watched.

Speculation and Valuations

While not seen as a full-blown bubble in public markets, there are concerns about speculative behavior, particularly in private markets with companies lacking cash flow and revenue. The rapid pace of change and disruption in the economy, coupled with a highly valued market, leaves few "safe havens."

Geopolitical and Policy Risks

The legality of Trump tariffs is being weighed by the Supreme Court, with potential for more uncertainty if they are struck down. The ongoing government shutdown is also a factor contributing to consumer sentiment and a lack of economic data.

Investment Strategies and Perspectives

Buying the Dip and Diversification

A pullback is seen as potentially constructive, allowing markets to reset. For clients with year-end bonuses, a pullback presents an opportunity to deploy cash. Rebalancing and global diversification are recommended, as US markets have underperformed some global markets.

AI as a Long-Term Theme

AI is considered a fundamental growth driver for the future, still in its "early innings." Investors are encouraged to have exposure to AI themes, focusing on companies showing early gains and expanding margins.

Defensive Sectors and Global Diversification

While tech is dominant, there's a suggestion to look at defensive sectors like healthcare and consumer staples, which offer growth without extreme multiples. Europe is highlighted as an attractive region due to lower valuations and strong earnings seasons, offering a counterbalance to US market concentration.

Gold and Alternative Assets

Gold is seen as a valid component of a conservative portfolio, but its high price currently makes it less attractive for investment accounts.

Federal Reserve Policy and Interest Rates

The Federal Reserve's policy is a key consideration. There's an expectation of rate cuts in December and potentially more next year, driven by concerns about the labor market and a belief that policy is too restrictive. However, some argue that sticky inflation in services like healthcare and education may limit the Fed's room to maneuver. The impact of interest rates on capex is diminishing as large companies fund investments through free cash flow. However, interest rates significantly affect small businesses and consumers.

The "Teflon Market" and Complacency

The market's resilience to negative news, dubbed the "Teflon market," is a recurring theme. Despite tariffs, government shutdowns, and high valuations, the market has continued to rise. This resilience, coupled with strong earnings and AI optimism, has led to a sense of complacency.

The K-Shaped Economy and Consumer Strain

The "K-shaped" nature of the economy is evident, with higher-income consumers driving resilience while lower and middle-income consumers face strain due to rising prices for essentials like housing and education. This divergence impacts consumer companies, with frontline consumer companies reporting consumer caution.

Specific Company and Sector Mentions

• Nvidia: Mentioned as a key player in the AI trade and a target of short positions.
• Palantir: Highlighted for its high valuation and being a target of short positions.
• OpenAI: Discussed in the context of its valuation and potential systemic risk due to circular financing.
• Amazon, Microsoft, Google: Seen as hyperscalers with accelerating cloud revenue growth, rewarded by the market.
• Meta Platforms: Noted for increasing capex spending with a more dubious ROI and timeline for payback, lacking a strong cloud business.
• Chipotle, Starbucks, McDonald's, Target: Consumer companies whose performance is being watched for signs of consumer strain.
• Viva Systems: A healthcare software provider seen as a defensive and offensive play, benefiting from data analytics and AI bots.
• Home Depot, McDonald's: Examples of companies that could benefit from falling interest rates.
• AV, Waste Management: Mentioned as defensive healthcare and services companies.

Conclusion

The market is characterized by strong earnings growth, particularly in the tech sector driven by AI, but also by significant bifurcation and concentration. While the "Teflon market" has shown resilience, potential risks include a weakening labor market, delayed impacts of tariffs, and speculative behavior in certain areas. Investors are advised to maintain exposure to AI themes, consider global diversification, and be mindful of valuations. A near-term economic slowdown is anticipated, but a recession is not seen as likely due to expected Fed rate cuts and fiscal tailwinds. A healthy pullback in the market is considered possible and could present buying opportunities in technology, industrials, and healthcare. Complacency and the K-shaped economy remain key areas to watch.