The sharp market swings of March through May were largely driven by concerns that emerged in the first quarter. Sticky inflation and fading hopes for Federal Reserve rate cuts weighed on equities, and the outbreak of war with Iran sent oil prices soaring 70%. Stocks corrected 8% before rebounding 20% as oil prices collapsed and inflation fears subsided.
The third quarter saw many of those same headwinds return. The war with Iran has dragged on, oil prices have climbed back above $90 per barrel, progress on inflation has stalled, and the Federal Reserve has reversed course and raised interest rates.
These developments may have slowed the market's advance (the S&P 500 gained just 2% during Q3), but the underlying economic and corporate fundamentals supporting equities have remained remarkably strong.
This commentary has been skeptical when it comes to the sustainability of above-trend earnings growth. After several quarters of double-digit earnings growth, Q1 earnings accelerated to 29% year-over-year. Last quarter’s commentary discussed how high expectations are increasingly likely to be setting up markets for disappointment. Instead of disappointing, however, Q2 earnings once again crushed expectations.
Q2 year-over-year earnings growth came in at a blistering 52%. That number far surpasses true economic activity growth, of course. A large percentage of that growth was the result of mega-cap companies marking-to-market their stakes in Anthropic and SpaceX. Backing out those distortions, however, still leaves earnings growth in the 30% range.
As we head into earnings season, analysts are expecting more of the same. FactSet currently anticipates earnings growth near 30% and suggests the final figure could exceed 35%.
There are plenty of reasons to add qualifiers to the earnings growth, but it cannot be denied that corporate fundamentals are currently quite strong. Looking beyond reported earnings to revenues, which are less affected by unrealized investment gains, we find top-line growth of 15% year-over-year in Q2, with another double-digit increase expected in Q3.
Looking ahead to the final quarter of the year, it remains unlikely that any correction would be spurred by true economic weakness. Instead, the greatest risks come from falling short of these lofty expectations. Outside of recession recoveries, earnings growth of this magnitude has been exceedingly rare and historically short-lived. These extraordinary results have set a very high bar, and markets may struggle to absorb even a modest deceleration in profits.
The strength underlying corporate earnings is also evident in broader economic data. PMI surveys show both the manufacturing and service sectors growing at a brisk pace. While some have been discouraged by sluggish hiring, demographic changes have likely constrained the pace of payroll growth. We prefer to look at initial jobless claims, which have fallen to their lowest levels in four years.
Economic growth and a tight labor market, combined with tariff effects and commodity strains from the war, have led to fairly persistent inflation. Year-over-year core PCE inflation (excluding food and energy) has remained stubbornly around 3%. This sticky inflation led the FOMC to raise interest rates at their September meeting.
The move was somewhat surprising. The new Fed Chair was chosen to contrast the more hawkish FOMC members, and there were data points (such as trimmed mean PCE) that suggested inflation may not be as systemic as the broader measures indicated. The chair has suggested, however, that the committee should offer deference to markets, and markets, which began the year expecting multiple rate cuts, were clear that rates should be higher.
2-year Treasury yields began the year below 3.5%, but reached 4.9% by the end of Q3. By quarter-end, 10-year Treasury yields had surged to 5.29%, their highest level since 2002.
So far, equity markets have largely shrugged in the face of rising rates. This is despite the fact that the AI buildout is increasingly financed through growing debt. Higher borrowing costs raise the hurdle for investments that already require extraordinary returns to justify their expense.
Optimistic forecasts expect strong ROI on massive AI-related capital expenditures, but eventually, those forecasts must be reconciled with cash flow realities. The cost of debt is a longer-term concern, but we are also beginning to see just how expensive this buildout has become, even for companies generating record revenues and earnings.
Alphabet posted negative free cash flow in Q2 – the company’s first negative FCF print since going public. This is the very same company that contributed the most to S&P 500 Q2 GAAP earnings. Amazon and Oracle have also posted negative free cash flows, with Meta not far from it. If these costs prove more persistent than markets anticipate, or rising competition and AI-related liabilities add further pressure, these profitability measures may reconcile in the wrong direction.
One reassuring data point among bulls has been the fall in P/E ratios. We have long been concerned with high earnings multiples. Our preferred measure, Price/Peak Earnings, has declined by about 15% from its peak, thanks to rising S&P 500 earnings. But the stark disconnect between earnings and cash flows brings into question just how cheap equities are. Long-term valuation measures, like the CAPE ratio, still have equity valuations at dotcom levels. Free cash flow yields are also at dotcom-era levels, while the Price/Sales ratio remains notably higher than the dotcom peak.
The apparent improvement in market valuations is not being shared equally. For the largest companies, much of the decline in earnings multiples has come from extraordinary profit growth. Elsewhere, valuations have become more attractive for a very different reason: share prices have fallen substantially, even as the underlying businesses have continued to perform well. While the major indices were near record highs in the final week of September, the equal-weight S&P 500 was on a seven-week losing streak. According to a recent Morgan Stanley note, more than 50% of Russell 3000 stocks have corrected more than 20% since the start of June.
The narratives driving the price dispersion are largely the same as they have been throughout the year. Inflation and rising interest rates are clear macroeconomic headwinds today, and AI disruption threatens the traditional economy in the future. As AI optimism grows, those stocks seen as susceptible to AI disruption have suffered, even as many of them defy that narrative with record revenues and earnings. This has created an environment where names that are sensitive to interest rates or vulnerable to AI disruption have increasingly moved in the opposite direction of the AI trade, often on a daily basis.
These types of price dispersions create opportunities, and our active Time Overlay approach once again began adding to our equity exposure in the second half of September.
As we noted when we increased exposure earlier this year, these divergences have frequently been resolved by out-of-favor stocks recovering rather than broader markets declining. We saw that dynamic play out during Q3.
That favorable outcome does not eliminate the risks posed by elevated broader-market valuations. Indeed, with earnings expectations unusually high and interest rates rising, the possibility that these divergences narrow through falling market prices cannot be dismissed.
Our emphasis remains on owning high-quality businesses at attractive prices while maintaining the flexibility to capitalize on further market weakness. We are entering the final quarter of the year with typical Time Overlay accounts targeting approximately 35% in cash, reflecting our continued caution about broader valuations while preserving substantial capacity to take advantage of new opportunities.