The U.S. economy is growing above trend. Last Thursday’s third release of Q2 2025 GDP was revised up from 3.29% to 3.84% with upward revisions to consumer spending on services, business fixed investment, and state/local government outlays. Fears over consumer spending slowing sharply this year appear to be misplaced.
One popular narrative prior to the report was that the economy has been totally dependent on AI capex spending to keep growing. AI is certainly boosting the economy but there are other pillars in its foundation of growth as well.
This good economic news leads to the question: How much can the Fed really cut rates if the economy is growing above potential while inflation runs materially above target for the fourth consecutive year? Maybe investors’ expectation of two more rate cuts this year is overly optimistic. How will the market react when the chances of those two cuts is reduced? This eventual realization by investors may add to the market’s choppiness and possibility we have its first real drawdown since the April low.
Stock valuations are one reason bears say we are in a bubble. Sure, the S&P 500 is trading at about 22x 2026 projected earnings, but a more detailed look shows that mega-cap tech stocks are skewing the P/E ratio much higher. A better way to look at valuations is to look at an equal-weighted P/E ratio which takes out the impact of the mega-caps. The equal-weight S&P 500 trades at about 16.5x 2026 forecast earnings, a significant discount to its market cap weighted cousin (source: Barron’s). And notably, the current equal-weight P/E ratio is about 15 points lower now than it was at the market peak in 2021. We acknowledge that mega-cap tech is trading at a premium valuation but that is where the growth is. And many investors flock to the best available growth in the market, especially with large caps.
RALLY LOSES STEAM
To say the stock market is due for a drawdown is an understatement. The S&P 500 has been ripping higher almost uninterrupted since the April lows without a pullback of more than 3%. Both the S&P 500 and NASDAQ are overbought. Markets that are overbought tend to mean-revert over time (they don’t stay that way forever). Many stocks are already in downtrends…except some of the most volatile ones. One of the best examples of extreme upside volatility is quantum computing stocks. A basket of four popular quantum computing stocks is up about 3,000% since last fall!
Just because markets are overbought doesn’t mean a sharp sell-off is guaranteed. Corrections can occur in terms of both price and time, so a period of sideways trading could alleviate these overbought conditions. If we do have a sharp sell-off, long term investors should view lower prices as an opportunity to upgrade portfolios – as we did in April. An overbought market doesn’t mean the bull is over – rather, a pause that refreshes is probably necessary.