2026 Q3 Commentary
With three quarters of the year now complete we are observing more divergences in markets than we have seen in a long time. From a bird’s eye perspective, markets seem to be marching along without much volatility, but looking more broadly, the picture becomes much more complicated.
In our prior commentary we mentioned a confluence of factors that could grab the attention of the markets: Fed hawkish policy shift, stickier inflation, mid-term election uncertainty, lofty earnings expectations, renewed higher oil prices, etc.
These have not disappointed. Oil has been persistently higher due to ongoing back and forth tussling with Iran and Russia/Ukraine. Inflation has been stickier. The Federal Reserve has taken a more hawkish tone since the Jackson Hole August meeting. And the November mid-terms are still looming.
All this and the S&P is up 12% for the year. Taking a deeper look, however, the market is being held up primarily by the tech sector. In Fact, over 46% of the S&P stocks are down for the year and 9 of the 11 sectors are underperforming the S&P, while 4 sectors are even negative. Gold is also significantly off its highs from earlier in the year. And the Dow Jones is up less than 6%, while the median stock in the S&P is only up about 4% for the year.
One might think this lopsided performance is unprecedented, but it is not. The statistics are similar to periods in the late 90s, in particular, 1995, 1998, and 1999.
The biggest disappointment however is saved for the heavy bond allocators (not us). After consecutive years of bad returns, bond returns have gone from bad to worse. Bonds are down 3% year to date (including dividends). To put into a longer-term perspective, a conservative investor might allocate somewhere between 50-70% in bonds. And since March of 2020 the return on that bond portfolio is actually negative (about a $7,000 loss for every $1 million invested!). More insulting is when compared against the stock market that has done extremely well over the same period.
The lesson is that “buy-and-hold” is contingent on either: 1) having a very long-time horizon or, 2) having a favorable starting point. This applies to any asset class, not just bonds.
The good news in the bond world is that rates are at the highest levels in close to 25 years! Ironically, they are now more hated than ever, but mathematically they show the best value in over two decades (huh, really?? Yes.). To us this means now is the time to start investing again in this universally reviled asset class. Does this mean that rates can’t or won’t go up more from here? Not at all, but the starting point to us looks very favorable within the greater context.
So why has the market been so resilient against the escalation in the risk factors that we mentioned. The answer: earnings and resilient economic growth. Earnings continue to blow away expectations at a level that has overcome the prevailing headwinds. This is primarily coming from the AI investment boom so much that the P/E ratio has been coming down while the market has been moving higher.
We have mentioned in prior writings the possibility of a fall correction. And this is still in the cards. However, underneath the hood, as we have explained, there have already been rolling corrections in the markets. Even the semi-conductor sector is down over 15% from its summer peak. The key to any further major downside volatility will come down to U.S. government interest rates, particularly the 10-year treasury. If the 10-year treasury continues its relentless march higher, to say 6%, this will ultimately cause the markets to correct. We will be watching this closely.
Taking a step back, if we compare today to the 90s. the evidence suggests that we are indeed in an AI bubble. Investing in a bubble can be extremely lucrative, especially in the later stages where markets usually go parabolic. The problem is that the pressure to participate is insatiable, and when every last buyer is invested, there is usually a large bear market in waiting, having devastating implications on portfolios (if still heavily invested that is). Like with other investment booms such as the canals, railroads, electrification, highways, consumer durables, and telecom/fiber, the pattern is all too familiar.
The AI investment boom is the mother of all investment booms. Don’t take our word on this. According to Columbia professor Stijn Van Nieuwerburgh, the average annual investment in AI as a percentage of GDP through 2032 is estimated to be 3.63%. To put into perspective, the second largest investment boom in U.S. history was the railroads (1870-90s) at 2.2% of GDP. (source WSJ Konrad Putzier and Justin Lahart). Wow! We are living through history.
We want to participate in this boom, while at the same time well knowing that all the massive expansions ended in investment disaster (with the exception of electrification). Why would it be different this time?
As we traverse the final months of the year, we are still mindful of a sharp correction in stock markets which would likely be triggered by a fresh spike in interest rates. This however might be ameliorated by a reversal of policy at the Fed and/or U.S. Treasury interventions. And with the markets having already experienced rolling corrections, this could end up being a buying opportunity.
The historical backdrop and recent data continue to lead us to follow the narrative that we are in a mid-to-late-cycle investment boom/bubble in the AI. This means that returns can continue to be very strong into 2027. Especially if the signaling from the Fed is that inflation is moderating and there is no need for further rate hikes.
The post mid-term election tailwinds are as follows: strong earnings, solid economic growth, AI productivity, Fed pivots dovish, inflation moderates, wall of worry market climb from negative sentiment, P/E multiple expansion, government gridlock, to name a few.
At the beginning of the year our view was that growth would exceed expectations and that it would be a choppy year, but ultimately higher. It has been a challenging year in that returns have been too heavily concentrated in a small handful of stocks in the technology sector. We believe that technology will continue to be the outperformer through this investment cycle and we will continue to add emphasis there. Also, for the first time in years, an allocation to bonds is compelling given how fast rates have climbed.
We still cannot forget that risk management is the most important part of the investment process. A 30% return in one year can be wiped away by a large loss the following year. Risk management allows us to stay closer to the “high-water mark” of the portfolio value. This is important mathematically because a large drawdown requires such a larger subsequent percentage return just to get back to the prior portfolio high. This is why it is more common to see a sleepy, yet consistent portfolio have a higher end-value than a portfolio that has huge up years but then suffers big drawdowns.
The reason we mention this is because we have seen this twice in our careers where the markets have dropped by over 50% and then taken years to recover. It has been some time since the last bear market, and a majority of advisors and some investors weren’t even around for the last one, much less the one before. For example, it took the Nasdaq 16 years to get back to where it was at the peak of 2000. It almost seems inevitable to us that there will be some variation of what has occurred in the prior bear markets (at least using history as a comparison). This is where risk management skills will shine and save potential devastation. Navigating the markets in 2022 was a sneak preview of this.
But for now, our expectations are that there is still more upside and that 2027 should be a strong year. We will, however, be data driven and risk management focused should the markets evolve differently.
Thank you for your trust.
The Vigilare Wealth Management Team
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