Q2 2026 Commentary
After a weak start to the year, equity markets rebounded to post their strongest quarter since 2020.
The gains were kicked off by a fragile ceasefire agreement with Iran in early April. Stocks had bottomed a few trading days earlier, but the April announcement saw oil prices collapse, and equity markets never looked back.
Though the newfound confidence was rooted in the de-escalation of the war in Iran, the primary beneficiaries of the rebound were those tied to the AI trade. Semiconductors led the way, with the PHLX Semiconductor index more than doubling from its late March low to its June high.
Private companies SpaceX, OpenAI and Anthropic all moved to benefit from the AI optimism by making progress towards going public. SpaceX executed the largest and most hyped IPO in history on June 12th. Anthropic and OpenAI confidentially filed their initial IPO paperwork with the SEC June 1st and June 8th, respectively.
These are not the only large companies seeking additional capital, as other major hyperscalers have been aggressively raising capital in debt markets as they burn through cash (much of it going to the semiconductor companies above). The returns on these investments will be critical to whether markets can grow into their high valuations.
The rush for capital did seem to spook markets slightly. The S&P 500 saw its quarterly high in early June. The subsequent SpaceX IPO had a very typical day-one performance for an IPO (admirable given the scale, but nothing special on a percentage basis). Reports stated OpenAI may wait until 2027 to launch its IPO, reflecting caution about the market’s capacity to absorb another exceptionally large offering.
Of course, any such delay could be met with significant regret. While some of the euphoria has been wearing off the capital-intensive AI plays, valuations remain extremely rich. As we have addressed in this commentary before, high valuations remain the biggest risk to this market, and these AI companies have not had to raise money in a normal valuation environment.
OpenAI was founded just over ten years ago. The past ten years have also marked the most expensive decade for equities in history. The average Price/Peak Earnings ratio over the last decade has been close to 24x. The Price/Peak Earnings ratio averaged closer to 19x during the previous 20-year period, which included the dotcom bubble. Today we are sitting closer to 27x. That places today’s market at a 40% premium to the average valuation of that period. Any move towards a normalization in prices would have very broad impacts, particularly on the most speculative areas of the market.
A reversion to those levels would require a 25-30% decline, or sustained earnings growth without commensurate market gains.
Markets are currently betting that continued earnings growth will reconcile today’s elevated valuations with underlying fundamentals. So far, earnings have supported that bet. In the first quarter, S&P 500 stocks saw year-over-year earnings growth above 20%. Estimates for Q2 foresee another 20% year-over-year quarter. The latest FactSet Earnings Insight report, noting that earnings tend to beat expectations, suggested that we may see earnings growth approach 30%.
It is worth noting that, when earnings are at all-time highs (not rebounding from a decline), we have only seen back-to-back quarters of 20% earnings growth twice in the last thirty years (and only one quarter of 30% earnings growth). These are becoming extremely high hurdles to clear.
And earnings estimates can be very wrong. When we discuss forward estimates and valuations, we like to remind readers that the market was not particularly expensive at the start of 2008 (which became the worst year since 1937), but earnings estimates were 40% too high.
Using earnings as a measure of success in this market may make valuations seem better than they are. With megacap companies pouring unprecedented sums into AI infrastructure, operating cash flows are mostly being reinvested into capital expenditures, meaning that those earnings are not making their way to investors’ pockets. S&P 500 free cash flows are at their lowest levels since COVID, and 2008 before that.
Other valuation measures paint a similarly concerning picture. The CAPE ratio exceeded 40 this quarter for the first time since the dotcom bubble. The Price/Sales ratio is near 3.7 – significantly higher than the dotcom peak near 2.5. Remember, wide profit margins are not immutable, but perhaps those metrics can be revisited in a future commentary.
As clients have experienced in recent years, an expensive market does not fully discourage us from participating in our active strategies. Time Overlay accounts entered Q2 nearly 90% invested in equities.
Performance for the quarter reflected a historic divergence between high-quality, low-volatility stocks (which comprise most of our universe), and the market as a whole (which was dominated by semiconductor stocks and momentum plays).
An Alpine Macro report noted that the performance gap between momentum and minimum volatility stocks reached its highest level in their data, exceeding past dramatic divergences in 2000, 2008 and 2021. A look at the current Master List shows the broadest underperformance of these “quality” names in at least 20 years.
Similar divergences have rectified to the upside, with a clear exception in 2025. Combined with recent moves, we have now seen a year-and-a-half period of muted returns for low-volatility stocks. Domestically, these stocks have returned less than 5% since their late 2024 highs (as measured by the USMV ETF).
Amidst that performance, many opportunities have presented themselves, leading to our high equity allocation. By the end of the second quarter, Time Overlay strategies had reduced their equity exposure to nearly 70%, but continued to hold on to a significantly discounted basket of high-quality stocks. The median holding among accounts following the strategy is more than 30% below its high. That makes our current basket one of the most attractively discounted portfolios we have held in the last fifteen years.
These trends have led to some contrasting ideas in this strategy. We see the market as extremely overvalued, but hold onto a large basket of stocks that we believe are significantly undervalued. Our long positions do not generally move opposite the market, but lately our conviction has been confirmed with many trading days where we have seen a clear inverse correlation to moves in AI names.
This inverse relationship has affected large swaths of the market. The offsetting activity has led to muted daily market volatility, but daily volatility among individual names has been growing. So far, Time Overlay strategies are benefiting from this increasing volatility, but it reflects growing risks to the broader market – even if most investors are not seeing it yet.
If markets do correct, it is more likely to be the result of disappointing earnings or succumbing to technical pressures. It is unlikely to be driven by any true economic weakness.
Fundamentally, everything is fine. As acknowledged above, earnings growth has been strong. Most measures clearly indicate continued economic growth, which has broadened to include both the services and manufacturing sectors. Inflation has been stubborn, but is not out of control, and falling oil prices should help assuage price pressures. The labor market has been the most contradictory data set, highlighted by low rates of job creation. The numbers seem to be skewed by unprecedented retirements and immigration controls, keeping the unemployment rate low. The number to watch remains initial jobless claims, which have stayed extremely low.
There is some added macro uncertainty with the new FOMC Chair Kevin Warsh. He has been intentionally opaque regarding his views on the path of monetary policy. There is no indication that his leadership will be deleterious, but untested policies could have unforeseen consequences.
As we head into the second half of the year, we are very optimistic about our current equity allocation, and have a growing cash allocation to take advantage of any further market dislocations or pullbacks.
Robert B. Drach
Drach Advisors LLC