December Investment Comments
From its April tariff-related trough to its recent peak, the S&P 500 gained more than 35%, though in recent weeks the market has faced greater resistance. The market’s move higher was powered by optimism surrounding AI, strong earnings growth, and a move to more accommodative policy by the Fed as it reduced interest rates. The more recent price action has been the result of growing concern that AI isn’t yet generating enough revenue or profits to justify the spending on infrastructure, the market’s perception that the Fed will be less aggressive with rate cuts by forgoing a rate reduction in December, and increasing scrutiny on potentially stretched valuations.
These pressures resulted in the benchmark closing below its 50-day average for the first time in nearly five months, breaking its second-longest stretch above this line in over 25 years. Bitcoin, a reasonable gauge of overall investor sentiment, has sold off sharply, briefly dropping below $90,000 after hitting a record high of over $126,000 in October. In one sign of the current environment, a columnist for The Wall Street Journal openly advocated for a “good, long bear market” to cure “dangerous complacency.” Setting aside the ill-considered desire for a long bear market, a doom-seeking piece chastising investors for imprudence captures the increasingly bifurcated sentiment of investors.
The current push and pull in the market has resulted in higher volatility, yet the S&P 500 has only effectively returned to September levels. Whether the decline from recent highs is simply a function of the market taking a breather after an impressive run or the precursor to a correction or worse remains to be seen. The year-to-date gain for the market-capitalization-weighted S&P 500 is over 13%, while the return for the equal-weighted S&P 500 has been more muted, up 5.5%. According to 3Fourteen Research, more stocks in the S&P 500 have trailed the index by 20% or more than have outperformed the index this year. Participation has been narrow, with the median stock in the S&P 500 up only slightly, a further indication of a market that continues to be driven higher mainly by mega-cap tech stocks.
The AI trade has been the dominant theme propelling markets this year, and any softness in the theme has largely been accompanied by rotation into other sectors. This has helped limit damage to the overall market during periods of softness for mega-cap tech, but the market is likely to follow the leaders should they keep declining. Concerns regarding an AI bubble have grown and center around the increasing use of debt to help fund the infrastructure buildout, the circular nature of financing deals, lengthening depreciation schedules, and questions whether the huge amounts of money going into the infrastructure buildout will be justified by reasonable returns.
AI bulls counter that demand for AI infrastructure remains overwhelming; Microsoft, Alphabet, Amazon, and Meta are expected to increase their combined AI spending by 34% over the next year to $440 billion and continue to highlight capacity constraints. Additionally, the companies making the largest investments are extremely profitable and not overly reliant on debt to fund the buildout. Bulls also believe we are only beginning to scratch the surface of AI-related productivity improvements that ultimately will prove the investment case and drive significantly greater utilization. They also point to valuations that appear more reasonable than in historical bubbles, as a current forward P/E of approximately 30x for Nvidia is a far cry from Cisco trading at a multiple closer to three times that in late 1999.
A rethinking of the path forward for the Fed is also weighing on sentiment. Expectations for a Fed rate cut at its December 9-10th meeting have come down from over 90% in October to essentially a coin flip. Following the Fed’s October meeting, where it lowered the Fed Funds target rate to a range of 3.75%-4.0%, Chair Powell reset expectations by indicating a December rate cut was far from a “foregone conclusion,” surprising investors. It is no coincidence the recent peak for the S&P 500 was achieved just prior to Powell’s remarks and the market has sold off since. While the Fed continues to balance the risks of stubborn inflation and weaker employment conditions, the expectation was that a softening labor market was the greater concern and that the Fed would be biased toward continued easing at its final meeting of the year.
The labor market has clearly slowed, but elevated inflation remains a problem. The government shutdown has impacted the availability of key data and resulted in limited visibility for policymakers. The last official data before the shutdown showed the Fed’s preferred inflation measure, the core Personal Consumption Expenditures Index, which excludes food and energy, remained sticky in August, up 2.9% over the prior year and higher than the Fed’s 2% target. As government data trickles out following its reopening, visibility for the Fed will improve, helping illuminate the path forward for rates. Consumer sentiment is around historic lows and continues to reflect softness, in part pressured by the government shutdown. Consumer spending accounts for roughly two-thirds of GDP, and the question remains: can consumers remain resilient with weaker job growth and inflation that continues to run at elevated levels?
The forward P/E ratio for the S&P 500 is over 22x. While multiples remain elevated relative to historical levels, earnings continue to help justify the optimism. Third-quarter earnings have yet to fully conclude, but the results so far have been strong. Earnings growth has been over 13%, well ahead of expectations. Furthermore, over a third of companies in the S&P 500 raised their outlooks in the quarter, the highest level since 2021 according to Bloomberg Intelligence. However, those companies missing expectations have been treated more harshly, with subsequent price declines greater than what is typically seen.
Full-year expectations reflect solid 12% earnings growth for the S&P 500. There has also been a trend in upward revisions to the EPS outlook for 2026, as analysts point to the potential benefit from lapping some of the tariff impact, tax benefits, and deregulation. Consensus expectations for next year are for an acceleration in earnings growth to 14%. Strong, accelerating growth is something the market typically responds favorably to and if this plays out it would be supportive for markets.
Given the host of current concerns that have weighed on equities, it is harder to count on typical seasonal strength to lift markets higher through the remainder of the year, though we remain open-minded to the possibility. Despite the recent shift in sentiment, the bull case can still be credibly made, and stocks remain not too far off their recent highs. While near-term calls are exceedingly difficult to make, owning growing, quality companies at reasonable valuations remains a sensible way to pursue long-term investment success.
James M. Skubik, CFA®