Q3 Earnings, Inflation, and AI…
Executive Summary:
Market Bifurcation and Earnings Divergence: While headline indices reached record highs, underlying market breadth remains weak, reflecting a steep divergence between AI-driven mega-caps and the average stock. The median S&P 500 company faces decelerating earnings and margin compression, though technical indicators are beginning to suggest early signs of selling exhaustion.
The Cost of Capital and AI Crowding: Persistent upward pressure on interest rates, with the 10-year U.S. Treasury yield holding around 5.2%, continues to tighten broader financial conditions. The relentless demand for funding from the hyperscaler AI capex cycle is competing with the rest of the economy for capital, acting as a direct tax on corporate margins and consumer cash flow.
The 60/40 Revival and Fixed Income Opportunity: With high-quality credit yields reaching the mid-5% to low-6% range, bonds now actively compete with equities on a risk-adjusted basis for the first time since the Global Financial Crisis. Investors should utilize this generational yield reset to add duration and restore fixed-income diversification to their portfolios.
Full Commentary:
Global capital markets navigated a tricky mix of record highs in the S&P 500 and Nasdaq last week, while underlying market breadth remained underwhelming before showing late-week signs of life. While headline indices painted a picture of resilience, headwinds across equities, fixed income, and commodities illustrate a market balancing robust corporate earnings against the realities of a higher-for-longer interest rate regime and unrelenting demand for capital from the AI capex cycle.
U.S. equities delivered a strong performance, with the S&P 500 gaining 1.2% for the week and closing above the 7,800 level for the first time in history. The Nasdaq also secured new record highs early in the week. However, the most notable technical development occurred beneath the surface. After a prolonged period of narrow, mega-cap dominance that masked a stealth correction for the average stock, market breadth improved subtly heading into Friday. Participation widened as 71% of S&P 500 members climbed, with capital rotating toward utilities and consumer staples. Despite this improving breadth among large caps, smaller companies continued to feel the pressure of elevated borrowing costs; the Russell 2000 lagged the broader market again, extending a cumulative 5.7% decline over the past five weeks.
Technical Breadth: Nascent Signs of Exhaustion
Market internals are currently offering tentative signals of selling exhaustion. Friday’s advance/decline reading pushed the NYSE McClellan Oscillator across the zero threshold to +27.00, up from -1.00 the prior session. Historically, crossing above the zero line from deeply depressed levels is the mechanical prerequisite to halt a structural liquidation spiral. The intermediate-term Summation Index ticked higher from -1,184.00 to -1,156.00. At sub-1,100 levels, the tape remains deeply washed out, but downside momentum is losing mathematical velocity. Net 52-week new lows contracted to 382 from 416, while short-term 20-day New Lows halted a multi-week surge. While a confirmed bullish crossover of 20-day Highs over Lows has not yet materialized, the shift from aggressive expansion to stabilization marks the requisite first phase of a classic washout sequence.
These early flickers remain unconfirmed and fragile. All prior counter-trend thrust attempts over the past month have failed amid an increase in either interest rate or oil volatility. Confirmation that an investable turn in breadth is underway requires sustained positive daily oscillator prints and a definitive contraction in new lows below 100 issues.
Fixed Income & Macro: The Cost of Capital Bite
In the bond market, the relentless upward pressure on rates took a brief breather, though yields remain parked near their highest levels since 2002. The benchmark 10-year U.S. Treasury yield snapped a six-week streak of increases to finish the week at 5.24%, while the 2-year note settled at 4.80%. Bond markets spent the week digesting the latest Federal Reserve meeting minutes, which revealed that most policymakers anticipate another rate hike before year-end. The Fed faces an increasingly complicated macroeconomic backdrop: while recent payroll data pointed to a softening labor market, one-year consumer inflation expectations have surged to their highest levels since May 2023, leaving the central bank in a difficult bind between growth and price stability.
Long-duration bond RSI readings have curled upward from deep sub-20 oversold extremes, suggesting forced duration liquidation has temporarily exhausted itself. However, the broader macro environment continues to tighten financial conditions. Mortgage rates near 8% and elevated corporate refinancing hurdles are creating an unavoidable transmission lag into capital expenditure and balance sheet health. Adding to the pinch of a higher cost of capital is a firm U.S. Dollar Index, coming off its fourth straight week of gains, paired with Brent crude holding above $100 per barrel. These factors act as a direct tax on corporate margins and consumer discretionary cash flow. As this tightening vice works through the system, forward real GDP growth faces an inevitable downshift over the next two to four quarters. While this drag limits near-term equity multiple expansion, it will eventually force a cyclical rollover in long-end yields—transforming today’s rate headwind into tomorrow's duration relief.
Gold, meanwhile, rose 1.3% on the week and has held above $4,100/oz even with U.S. real rates at multi-decade highs. Goldman's futures desk noted that positioning has reset meaningfully, citing that systematic strategies are at the 0th percentile on a 1-year lookback, while CFTC managed money net length has normalized to average levels. The desk concluded that adding length in gold looks increasingly attractive.
Earnings Season: Peak Growth Meets Peak Concentration
Returning to the S&P 500, it is vital to emphasize how heavily bifurcated the index has become. Since August 27, the S&P is up 1.28% while the S&P ex-AI is down a little over 5%. This rolling 30-day gap is near the widest since the AI trade began in January 2023. Nearly 60% of stocks are down more than 20% from their highs. This structural divergence leaves us with two takeaways: a significant amount of pain is already priced into the median company, and the market must soon resolve whether the leaders catch-down to the laggards or vice versa.
This week, investor attention will pivot to the CPI inflation report and the start of Q3 earnings season with the big banks reporting, both on Tuesday. Consensus expects S&P 500 EPS growth of 27% year-over-year, the highest estimate since 2021. However, the earnings picture mirrors the bifurcation playing out in the equity market. Data from Goldman Sachs indicates the top 10 contributors are expected to drive 68% of S&P EPS growth for Q3—up from 48% in Q2 and 47% in Q1. Notably, Micron (MU) and Nvidia (NVDA) will account for half of that 68%.
For the median S&P 500 stock, the boom is already fading. Consensus expects EPS growth of just 9% in Q3, down from 14% in Q2, with analysts projecting a sequential deceleration in every sector except Info Tech and Comm Services. Input costs are biting: analysts have cut the median stock's Q3 profit margin estimate by 11 basis points since the start of the quarter across all sectors except Info Tech.
While Q3 will likely mark the third consecutive quarter of 25% EPS growth, the focus must now shift to how stocks react to these results. The true read will arrive in late October when most Mega-Cap companies report. Forward outlook and future capex guidance will be critical, as Q3 is likely to mark the cycle high for EPS growth, with growth decelerating in each of the following three quarters. Analysts also expect Q3 to mark the high in hyperscaler capex growth, which is currently running north of 100%. It is important to distinguish between "peak earnings growth"—a deceleration in an ongoing growth trend—and "peak absolute growth," which signifies a transition to contraction. While absolute contraction is unlikely, the anticipated slowing from this point forward is well understood across Wall Street. Nevertheless, peak economic growth, peak capex growth, and peak EPS growth arriving simultaneously, with stocks at record valuations, creates the kind of setup that tends to be described as well-understood right up until it isn't.
The AI Capex Cycle and the Cost of Capital
The trend in stocks remains upward primarily due to AI, but it is important to recognize that one of the major drivers of rising rates is the competition for funding from hyperscalers pursuing AI supremacy. Ultimately, the capital market backdrop boils down to this single trade.
Bulls will argue that a market hitting new highs while shrugging off a 5.24% 10-year yield, a hawkish Fed, and an OpenAI revenue scare is a market that wants to go higher. While yields and equities can rise together when growth remains strong, historical precedent shows that when this kind of financial stress persists—whether during the 2011 sovereign crisis, the early 2020 pandemic turmoil, or the rapid rate hikes of 2022—risk assets cannot shrug it off indefinitely. Unless broader financial stress disappears quickly, risk assets will come under mounting pressure.
Hyperscalers pursuing 30-50% IRRs on their AI capex cycles may not care if borrowing costs 8% instead of 7%, but this cost of capital increase weighs heavily on every other borrower lacking the earnings profile or balance sheet strength of Mega-Cap tech companies. A stronger dollar, higher energy prices, sticky inflation, and higher borrowing rates create a toxic cocktail that will slow the rest of the economy. Economists estimate that 98 basis points of the 108-basis-point selloff in 10-year yields has come from real rates, and that 30-year real yields at 3.33% are near the top of the post-2010 range. This has put the Treasury market on a one-way path to find either the level at which AI issuance finally becomes sensitive to yields, or the level at which something else in the economy breaks.
This places an immense burden on the AI cycle to carry the economy. Jim Bianco recently contextualized this reliance in an X thread over the weekend, noting that 41 AI-related companies accounted for 48.68% of the S&P 500's combined market capitalization, leaving the remaining 459 companies to account for 51.32%.
The AI revolution will move in fits and starts. The next phase of the AI trade is less about who benefits from the spending boom, and more about who can sustain the economics once spending growth normalizes. Hyperscaler capex investment is still ramping, but the market must be on the lookout for a plateauing in capex intentions.
It’s a widely held view that Hyperscaler capex investment is still ramping – call that a ‘known, known’ – see the chart below from Apollo’s Torsten Slok. What we don’t know and have to be on the lookout for is the inflection from a rate of change slowing in capex investment (also a known, known) to a plateauing in capex intentions. Or said differently that first hyperscaler announcement that they are cutting capex investment from elevated expectations. The AI boom is still growing, but the market is starting to ask who ultimately gets paid.
Portfolio Strategy: The 60/40 Revival and Clarifying Allocations
Admittedly, I waffle from day to day. Some days, I am emboldened and constructive on a market that refuses to break under relentless pressure from every adjacent asset class. On other days, I wonder whether I’m too complacent about the growing pile of risks (with the melt-up in global bond yields at the top of the list) not to mention the discomfort of leaning against the time-tested adage of "not fighting the Fed." I know we all crave conviction and certainty; it makes us feel better to be around someone projecting that kind of energy, even at times when we know they are full of s*&t. But I find it difficult to trust anyone in the investing arena who comports themselves with absolute certainty given current conditions. That shouldn’t scare investors. If anything, a heavy dose of humility and skepticism (both bullish and bearish) are valuable investing characteristics to possess today.
With that baseline of skepticism in mind, the burden of proof continues to fall squarely on the bear camp to prove the bull thesis wrong. Historically, stocks go up over time and finish positive seven out of every ten years. This upward bias is supported by structural changes over the past two decades, including the embrace of passive investing and the rise of monopolistic companies that validate their trillion-dollar market caps with exceptional fundamentals. Yes, this has its own side effects—elevated concentration within the equity market, less investor rigor, regulatory capture, and the dangerous imbalance of a highly financialized U.S. economy. All of which thought leader Adam Butler captured in a thought-provoking X post last week:
“I'll say it again for the AI risk experts in the back:
We've already run a real life, large scale experiment on what happens when a superintelligence is unleashed on a narrow objective.
Look no further than U.S. capital markets.
Millions of investors, analysts, traders and algorithms, backed by trillions of dollars and wired together through prices, all chasing one goal: the highest risk-adjusted return on capital. And it is spectacularly good at its job. It funds the best ideas, punishes the worst ones, and turns new information into prices faster than any of us can react. No individual can out-think it. 99+ percent of professionals can't beat it.
But look at what else it's done along the way:
- Optimized the measure instead of the intent. Quarterly earnings became the scoreboard, so companies learned to manage the scoreboard.
- Treated anything without a price as free. Pollution, addiction, obesity, depression, political fragmentation, fragile supply chains, the long-term health of the communities it operates in.
- Found every gap in the rules, then paid lobbyists to help write the next set and pull up the ladder behind incumbents.
- Remade the world around its objective. Companies, pension funds and our retirement accounts now answer to the S&P 500.
- Made itself impossible to switch off, because everything else now depends on it.
None of this required malice. Nobody sat in a room and chose these outcomes. It's simply what a very capable optimizer does when its objective is a narrow proxy for what we actually care about.
And note that we never solved this alignment problem. We've managed it, imperfectly, with regulation, taxes, disclosure rules and the occasional crisis to show us where the guardrails were missing. Over time, the market has captured the institutions designed to constrain it. We've been at it the better part of a century, and the misalignment is the worst it's ever been. So the next time someone tells you AI is only dangerous if it "wants" something bad, or if its goals are mis-specified, point them at the S&P 500. It doesn't want anything. It just optimizes.
That's the whole problem.”
This brings me to last week’s missive, which garnered the most feedback from readers of any commentary I have penned this year. I want to take a moment to walk back and clarify a specific data point I referenced regarding Baby Boomer asset allocations, as the nuance is critical to the broader portfolio strategy I was attempting to convey.
Last week, I cited Federal Reserve data to highlight a 55% equity and 5% fixed-income metric. To be absolutely precise: the 55% figure does not represent the average Boomer’s internal portfolio allocation to stocks. Rather, it represents their generational ownership share of the entire U.S. stock market. Baby Boomers own roughly 54% to 55% of all corporate equities and mutual fund shares in the country. When looking at their own balance sheets—which include massive multi-trillion-dollar allocations to real estate, private businesses, and defined-benefit pensions—equities constitute roughly 24% of their total wealth.
However, the crucial takeaway from the Federal Reserve's Distributional Financial Accounts remains fully intact: direct holdings of debt securities—fixed income—make up an incredibly small sliver of their financial assets, hovering around 5%. Over the past fifteen years of zero-interest-rate policy, investors were effectively forced out on the risk curve because bonds mathematically failed to meet basic portfolio return hurdles.
With the move up in interest rates over the past six months to multi-decade highs almost across the curve, bonds effectively compete with equities on a risk-adjusted basis for the first time since prior to the GFC. At current mid-5% to low-6% rates on high-quality credits, such return profiles can meet most investors' long-term return needs, meaning investors no longer need to take excessive risks in their portfolios. This was the major point I was trying to convey: not to shun risk entirely or abandon one's equities, but rather to highlight that bonds, at current interest rates, provide a return profile that "scratches a lot of itches," if you catch my drift.
The 60/40 portfolio, which many left for dead, is back. At current interest rate levels, bonds can finally provide meaningful diversification benefits to a portfolio, especially in a debt-laden global economy that risks tipping into a debt spiral if rates climb much higher. The bottom line is not to fear equities—they are a necessary part of a prudent long-term investment portfolio—but rather to embrace bonds and recognize that investors should not be fearful about adding duration to their fixed-income allocations to lock in these generationally attractive yields.
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