October Investment Comments
Markets have staged a strong recovery from the April lows, with the S&P 500 up more than 30% and hovering around all-time highs. Though there has been a recent broadening out in anticipation of interest rate cuts at the Fed’s September meeting, the market has been largely driven by narrow leadership tied to the AI theme. Oracle’s most recent quarterly earnings announcement simply underscored this, as the company highlighted key contract wins related to its role as a provider of AI computing capacity that are projected to send revenue in its cloud-computing business up 700% over the next three years. Shares surged more than 35% and Oracle added approximately $250 billion to its market capitalization. AI remains very much at the forefront of investors’ minds.
AI may be the dominant theme, but markets have also responded to increased expectations for rate cuts following soft labor reports in July and August. Smaller capitalization companies, which generally are more indebted and therefore stand to benefit from lower rates, have begun to perk up. Since the beginning of August, the Russell 2000 has outpaced the S&P 500, but the small cap benchmark remains well behind the traditional benchmark for the year.
Until recently, the Fed perceived balanced risks related to both sides of its dual mandate of price stability and full employment. However, the July and August labor reports were disappointing. The July labor report showed the addition of 73,000 jobs but significant downward revisions to May and June reduced reported jobs growth for those months by a combined 258,000. The August report reflected just 22,000 new jobs added versus expectations of closer to 75,000, and a further revision lower for June that indicated the economy lost jobs for the month, the first decline since December 2020. Job gains on average for the three months ended August have averaged just 29,000, the lowest since the pandemic. The unemployment rate in August also ticked higher to 4.3% from 4.2%.
The softening in the labor market was further underscored by revised job numbers released by the Bureau of Labor Statistics showing the U.S. added 911,000 fewer jobs over the 12 months ended in March, versus a prior indication of 1.79 million jobs added over that time. Given the building evidence the labor market has been much weaker than previously thought, the next labor report on October 3rd will be closely watched.
In a nod toward its rising concern about increasing labor market risks, the Fed reduced rates by 0.25% in September and projects two more 0.25% cuts this year. The market is generally aligned with this outlook. Fed projections from the September meeting show a median expected neutral rate, which neither stimulates, nor holds back growth as around 3%, though estimates of the neutral rate have increased in recent years and there is a broad range of estimates.
Despite increased concerns surrounding employment, bullish stock market behavior leading into the September Fed meeting is indicative of a belief the Fed will move quickly enough to keep the economy from falling into a recession. This also leads to the somewhat unusual scenario where rates are being reduced while markets are near all-time highs and earnings are projected to continue on a solid growth trajectory. Rate cuts have generally been positive for markets outside of recessions. Ned Davis Research has pointed out that going back to the 1970’s, the S&P 500 has been up by 15%, on average, a year after the Fed resumed cutting rates following a pause of six months or more, as is the case currently. The path of rate cuts from here, and the circumstances surrounding those cuts, will be important.
Though the Fed highlighted the balance of risks has tilted in favor of the labor market, inflation risks have not fully gone away. Longer-term inflation expectations remain anchored, but inflation readings continue to run above the Fed’s 2% target. In August, the core Consumer Price Index excluding food and energy rose 3.1% versus the prior year, in line with expectations. In the 12 months through August, the Producer-Price Index was more encouraging, up 2.6%. Based on the CPI and PPI data for August, the Fed’s preferred measure of inflation, the core Personal Consumption Expenditures price index is forecast to have increased 2.9% on a 12-month basis in August, in line with July. Tariffs complicate the inflation outlook, but Fed Chair Jerome Powell more recently suggested the effects of tariffs on goods prices would probably be relatively short-lived, while simultaneously acknowledging the possibility tariffs could result in a more lasting inflation problem, even if that is not his base case.
Gold has benefitted from the belief the Fed will tolerate elevated inflation as it works to counter a slowdown in the employment market. The metal is up approximately 40% so far this year and has also benefited as short- and long-term rates have come down. The yield on the two-year Treasury has dropped to approximately 3.5% from 4.25% at the start of the year, while the yield on the 10-year Treasury has declined from 4.6% to 4.0%. The move in the latter has spurred some activity in the mortgage market though it remains relatively quiet.
According to FactSet, the forward 12-month P/E ratio for the S&P 500 is 22.5x, which remains elevated relative to history. Given market strength so far this year there is understandable hand wringing regarding potentially stretched valuations. The Magnificent Seven trade at a premium to the rest of the market but also generate most of the earnings growth. Looking at sectors, Bloomberg reports the tech sector is up more than 25% over the past year, but this has been matched by earnings growth. For the S&P 500 ex-technology, a 13% gain has outpaced profit growth of just over 6%. Of course, markets are forward-looking so this does not tell the full story, but it does offer some insight into the expectations of market participants.
The bar for earnings growth in the back half of the year has been lowered. As Morgan Stanley points out, company earnings for both the first and second quarters of the year comfortably exceeded consensus expectations, yet full year earnings estimates for both 2025 and 2026 have come down from where they were just prior to Q1 results. Current consensus expectations for earnings growth reflect nearly 11% in 2025 and approximately a 14% advance in 2026. If corporate earnings close out the year strong, there is a reasonable case for 2026 estimates to be nudged higher.
As always, there are risks in the market. When looking for what might lead to additional pressure for stocks, there are plenty of candidates. Given the importance of the AI theme, any disruption to the narrative would weigh on stocks more broadly. Signs the economy is cooling faster than expected, or that the Fed is not responding quickly enough to further weakening in the labor market, or if inflation starts marching higher, would also present headwinds for equity investors. Geopolitical issues also remain in the mix. Uncertainty continues to build at the same time valuations are elevated. A reasonable case can be made in favor of continued market strength on the back of the AI theme and rising corporate earnings, but additional caution also seems prudent in the current environment.
James M. Skubik, CFA®