Forechecking the Froth
Executive Summary:
Market Reversal and Immediate Headwinds: A sudden and aggressive sell-off broke a nine-week winning streak, heavily impacting the semiconductor, AI, and broader tech sectors. This broad-based drawdown was driven by multiple factors, including hawkish Federal Reserve expectations following a strong jobs report, an influx of new equity supply, and ongoing geopolitical conflicts, resulting in a necessary cleansing of short-term market excess.
Tightening Financial Conditions: A resilient labor market is complicating monetary policy, causing two-year Treasury yields to surge to 16-month highs as markets price in a "higher for longer" interest rate environment. The resulting tightening of financial conditions and rapid flattening of the yield curve act as kryptonite to high-momentum trades, warranting a more measured approach to portfolio positioning.
AI Capex Concerns and Strategic Positioning: While strong earnings growth indicates the market is not in a 2000-style bubble, the massive capital expenditures required for AI infrastructure and the threat of Chinese competition raise significant concerns regarding future returns on invested capital. Underlying economic fundamentals and earnings remain supportive of the bull market continuing, but some near-term caution is warranted until inflation and geopolitical pressures resolve.
Full Commentary:
Friday’s price action was a violent reminder that parabolic moves up – like what we’ve seen in the semiconductor, memory, AI, and Korea equities over the past two months – can experience similarly swift and aggressive reversals to the downside. The SOX Semiconductor Index sagged by -10.3%, deflating its market cap by -$1.3 trillion. Micron Technology, Intel, Super Micro Computer, and Sandisk all lost more than -11%. Cisco and Nvidia dropped by more than -6%. Heavy equipment manufacturer Caterpillar, lately an AI play because of its power and energy business, fell -3.8%.
One can attribute the late week sell-off in risk assets to a host of factors: oncoming equity supply (SpaceX IPO at the end of the week), a combination of sticky inflation and resilient growth (Friday’s better than expected jobs report) forcing the Fed to continue with a hawkish bias, the inability of the U.S. to extricate itself from the Iran conflict while the Strait of Hormuz remains effectively closed, sentiment and positioning reaching bullish extremes and / or a slew of other contributing factors that ultimately culminated with a necessary cleansing of short-term excess.
Maybe it was Broadcom’s AI revenue guidance coming up short that brought some sobriety to the party; the only question is whether this is an inflection point in the AI trade or a pause that refreshes? In addition to Broadcom, Meta's now-contemplated large equity raise, similar to what Alphabet recently announced, is also raising concerns about balance sheet issues and stock dilution. For perspective, all of this very recent angst and anxiety is taking hold only after Micron’s stock price skyrocketed by 195% between the end of March and Thursday’s close, and, in the process, became the twelfth company to achieve $1 trillion market cap status.
As you can see, you can pick your culprit to explain ‘why’ things happened, but more important is the ‘what’ that happened, which is that stocks gave back some of what was an epic nine-week winning streak that saw the S&P 500 up 18% over the past two months. So, while it was a painful gut check, it is a necessary one that saw the Nasdaq Composite plunge -4.2% on Friday – the largest one-day point decline (-1,121) in the history of the index. Keep in mind the preconditions for the Tech sector's decline, with the Nasdaq in one of the most technically extended setups we have seen in years. As recently as last Wednesday’s close, the SOX semiconductor index was trading +76% above its 200-day-moving-average – the highest reading since March 2000. Friday’s selloff compressed this gap ~22% in a single session.
The S&P 500 saw a -$1.8 trillion wipeout of its valuation with Friday’s -2.6% drubbing. With no stone being left unturned, the Russell 2000 index of smaller companies lost -3.5% of its value, Gold was hammered to the tune of -3.65%, foreign stocks as measured by the ETF ACWX fell-2.98%, and Emerging Markets (given their exposure to Korea and Taiwan) got clobbered -5.98% in what ended up being a broad-based drawdown. There were a few areas that bucked the trend of what was an otherwise miserable day in the equity market, with Consumer Staples (P&G, Walmart, and Coca-Cola), Healthcare (J&J, UNH, MRK), Verizon, and big banks (JPM) on the receiving end of capital rotating their way.
As for the May jobs report released on Friday, it was solid at the headline level, with +172k jobs created. I have some doubts that this level of job creation can be sustained, given that the job gains were highly concentrated in two sectors: Leisure & Hospitality (+70k jobs) and non-education local government (+50k), which many economists are attributing to hiring in preparation for the World Cup. Nevertheless, we did see the job tallies for March and April revised up by +93k, which brings the three-month average to +188k. Look, I don’t put much stock in any monthly data point any more given the measurement error we’ve seen since COVID, but you can’t deny we’ve seen an acceleration in the labor market so far in 2026 (+114k jobs per month) vs. 2025 (+10k jobs per month). This is good news and its occurring with wage pressures being subdued. Combine this with a robust corporate earnings backdrop, and it's hard to get bearish on equities outside of episodic bouts of downside volatility (otherwise known as non-trending corrections).
What complicates this for investors is the domino effect it has on the Fed and, therefore, interest rates (the price of money). On Friday, the yield on two-year T-notes surged +10 basis points to 4.15%, its highest close in sixteen months. Let me remind you that two-year yields are the most reliable market-based proxy for investor expectations regarding the future path of US monetary policy rates. This is a deep, liquid market that reflects not just where Fed Funds are today, but also where they will most likely go over the next 24 months. When 2-year yields are rising or falling, it means the market expects the Fed to raise or lower rates in the near future.
Therefore, when 2-year Treasury yields break to a new 12-month high, as they did on Friday, it's an important market signal to pay attention to. Two-year Treasury yields are currently 53 basis points above Fed Funds (4.15% versus 3.62%), which could be (though not necessarily) the market's way of saying the Fed is behind the curve in containing potential inflation. However, it’s not abnormal for the yield on the 2-year Treasury to trade above the Fed Funds rate. Since 1990, 2-year yields have averaged +36 basis points above then-current Fed Funds rates. This is a reasonable estimate of what Treasury investors require as a premium to overnight rates, both to compensate them for lending capital over a longer timeframe and the uncertainty over where the Fed will actually take rates. A gap that would grab my attention would be something like what we saw back in 2022, when 2-year Treasuries yielded 200 basis points more than Fed Funds. Then-Chair Powell ignored that hint, saying in May that the FOMC was not considering 75 basis point rate hikes. The market ended up being right: the Fed’s next 4 moves were 75 basis point increases.
Following the jobs data, the futures market slapped a 72% probability of at least one quarter-percentage-point hike in the Fed’s current target range of 3.50% to 3.75% by December. In fact, we are up to 27% odds of at least two rate increases this year (still low odds, but it's the direction of change that matters), up from 12% before the jobs data were released Friday morning – with the first volley now a toss-up as early as the October FOMC meeting (the market-based probability was 20% a month ago). With that prospect, the 10-year Treasury yield popped back above 4.50% (the level that has tended to give stocks trouble), while pushing the dollar up and gold down sharply (bullion now down over 18% from its late January peak). The long bond, mind you, barely budged, and at 5.0% is actually -18 basis points lower than it was at the mid-May peak. This rapid flattening of the yield curve and the tightening of financial conditions are kryptonite for the high-beta/momentum trade.
Alright, let me try to pull all of this together with some thoughts on markets and strategy. For starters, I think investors should respect Friday’s nasty reversal as an indication that caution is warranted. If I were to simplify it, I would say that the economic and fundamental backdrop is becoming less supportive of a continuation of the rampant euphoria of the past couple of months. Economic and earnings data have surprised to the upside, which is why equities went on the ramp they did, and that is now priced in. Now we must contend with the second derivative effects – higher for longer interest rates, companies rushing to go public with the most aggressive increase in equity supply maybe in the history of markets (SpaceX $1.7 trillion market cap, Anthropic $900 billion, and OpenAI $850 billion), not to mention hyperscalers tapping both the debt and equity markets (Alphabet and maybe Meta) which equates to additional liquidity drain from somewhere, and Treasury bond supply continues to flood the market with a Federal deficit running close to another $2 trillion this fiscal year. All the while, global central banks are tilting towards a hawkish bias.
This isn’t me playing chicken little in calling a market top or putting on a bear suit, but rather an acknowledgment that Friday served as a reminder that it's all the ‘same trade’. Outside of some defensive areas in the equity market, almost all major asset classes traded lower: stocks down, bonds down, commodities down, precious metals down, credit down…it was all just varying degrees of bad with cash being the only major asset class that avoided decapitation. It didn’t matter if a certain investment theme had the best secular setup in existence; if it was a risk asset, it got hit. That gets my attention and raises the antenna to wait and watch in the ensuing days/weeks.
As for the bubble narrative and comparisons to 2000, I’m not in that camp as I think the fundamental backdrop is materially different from back then. Consensus forward S&P EPS estimates have risen +16% YTD, which are actually outpacing the +8% move in the index itself. Unlike prior speculative peaks, the rally has largely been driven by earnings revisions rather than pure multiple expansion. AI capex, memory tightness, datacenter bottlenecks, power constraints, and semiconductor supply/demand dynamics all still look very real. That doesn’t mean I don’t have doubts, I very much do especially when I see CEOs at the heart of this AI renaissance shed light on the mismatch between cost and ROIC (return on invested capital). Sam Altman, CEO of OpenAI, said that “the cost question came up quite suddenly. At the beginning of 2026, the issue never came up. Now, AI costs are a huge issue”.
We also had IBM CEO Arvind Krishna estimating that the industry needs $6-$8 billion in total capex for data center and chip buildout. To cover that expense over seven years, companies would need $1-$2 trillion in new annual revenue (his math, not mine). Krishna goes on to say that he doesn’t believe that revenue exists and that only two or three companies will succeed at building leading AI models. Everyone else is spending to stay in a race most of them will lose. Wow. If true, this puts into context why the hyperscalers are investing like it’s a winner-take-all outcome, and they don’t want to be on the losing end.
Let me walk you through a little bit of back-of-the-envelope math. If we have $8 trillion in capex (investment) that generates a 12% ROIC, it generates $960 billion in profit after tax. If you were to assume a 30% profit margin on $960 billion after tax profit, that equates to roughly $3.2 trillion ($960/30%) in yearly revenue to square the math. For context, total global IT spend across all sectors (hardware, software, IT services, and telecom) is currently around $5 trillion per year. For the hyperscalers to hit a $15 trillion cumulative target, the AI ecosystem would need to capture an unprecedented, entirely new share of global GDP, rather than just cannibalizing existing enterprise software budgets.
Not to pile on, but this is before considering other competitors, such as China’s Deepseek, with companies looking for alternatives to U.S. models that are much more expensive. Another analyst whom I have a lot of respect for, Louis-Vincent Gave, has an extensive background in researching the Chinese economy and companies, and frequently points out that “when China enters a room, profits walk out.” Think of industries like solar panels, steel, aluminum, shipbuilding, and electric vehicles. These are all industries in which China has come to dominate, making it uneconomic to compete.
What’s concerning for U.S. tech companies is that China has repeatedly told the world that it has its sights on AI, semiconductors, and the high-end Tech space. Yet the world seems oblivious to the danger. Not that the U.S. is inferior, as we have the best Tech companies in the world, but competing against a foreign entity where profit isn’t a motivating factor is a concern for this humble analyst. Some seem to doubt that China has the technological know-how (they said the same about solar panels and EV’s), but have you driven or read the reviews on the newest BYD? Sure, perhaps there is a national security threat, but don’t be naïve to think that Chinese EV’s aren’t in the U.S. in part because if they were, they would put U.S. auto manufacturers out of business with their bloated cost structures. Some say that the West will never transfer the technology, yet this hasn’t stopped China from stealing trade secrets or ignoring patent laws.
All I’m getting at is that, as exciting as the AI potential can be and will be, it's not a risk-free venture for investors or the companies pursuing it. Yes, these MegaCap monopolies have proven time and again that they deserve the benefit of the doubt, this time included, but keep an open mind while going along for the ride.
In a nutshell, I’m cautious on the market for now. The underlying fundamentals remain supportive of the bull market: robust earnings outlook, resilient economic growth, inflation pressures starting to subside in 2-3 months, and a labor market holding firm. This is why I think investors should continue to lean portfolios toward growth, but not be all in at the moment.
What would turn me more optimistic or outright bullish would be a clear resolution on the U.S. / Iran conflict. This would likely deflate elevated volatility and remove inflationary pressures from high oil prices. This scenario also assumes earnings and economic growth continue on their current trends.
What would turn me more pessimistic or outright bearish would be a combination of hawkish inflation prints, bond yields breaking above recent ceilings, the U.S. dollar breaking out to a new high, and deterioration in earnings estimates.
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