We are in the heart of earnings season, and it has been an excellent one. About 64% of S&P 500 companies have reported so far. The latest forecast for the quarter is 10.7% EPS growth, about 5.3% above initial estimates going into the quarter – or about double the initial estimate! The forecast for calendar year 2025 is now 11.2% earnings growth with 14.0% slated for 2026 (source for all growth estimates: FactSet). How can the 2026 EPS growth estimate be so high? Two reasons: solid forecast GDP growth of 2.0-2.5%, and near-record profit margins. Continued strong profit growth is one of the reasons we remain bullish.
Here is an update on tariffs: It looks like the effective rate is now 11% – lower than feared during the tariff tantrum earlier this year. Apparently consumers are paying the bulk of them (but it is not curtailing overall strong consumer spending). How can we tell corporations are not absorbing much of the tariff costs? We see no evidence of decelerating corporate margins that would indicate costs are being borne by companies.
Has inflation spiked from President Trump’s tariffs as feared? No, but they are having some impact on the CPI, lifting it from the mid 2s to the high 2s. This is enough to keep the Fed concerned about inflation and may certainly impact their decision to keep cutting rates in the future, starting with the next meeting in December. The other major consideration by the Fed is the weakening labor market. But will low hiring persist in the face of very strong consumer spending and high profit margins? We doubt it. Recent ADP data suggests that employment declines have not accelerated to the downside. There is a material risk to investors that the Fed doesn’t deliver on market expectations for further rate cuts.
Major stock market indexes like the S&P 500 and NASDAQ are at all-time highs yet many stocks are in correction territory. Market breadth has been lousy. We mentioned in our last commentary that the average stock in the S&P 500 is 15% off its high. The median stock in the S&P 500 is only up 3% YTD with almost half of the index stocks down for the year (source: Drach Market Research). How can that be? The major indexes are market-cap weighted which means the largest stocks drive the indexes. Ten stocks account for 40% of the S&P 500 which points to extreme concentration. The largest stocks are rising while the foot soldiers are in decline. The drawdown we have been waiting for is here. This is probably a necessary development given the surge in share prices since the low in April. But the next rally phase won’t start until this underlying weakness is over. Don’t let the indexes fool you. Many stocks are correcting in spite of new index highs. We see this in our client portfolios.
AI BOOM UPDATE
Bears say the AI boom can’t last forever and they are right – but we see no current signs of a slowdown. There is too much capital chasing the AI space for the narrative to downshift. We see the boom continuing until a sufficiently large negative catalyst emerges to shift psychology in reverse. This may not come for a while.
Bears are pointing to two AI industry developments they see as evidence of excess in the story. These two new factors also concern us and may cause continued short-term choppiness in AI stocks. First, there have been a series of corporate bond and loan issues in a rise of debt financing for the AI capex boom. Investments in capex are no longer being financed solely by corporate cash flows. Oracle and Meta are two companies that come to mind that have recently used debt financing. Both stocks were hit hard on their announcements to use debt. Oracle stock was hit particularly hard. Meta has more impressive cash flows thanks to its social media businesses but is spending more aggressively.
Second, some AI companies are agreeing to “circular” deals. A few weeks ago Nvidia announced it would invest up to $100 billion in OpenAI in stages as that company deploys Nvidia chips into data centers. Nvidia is purchasing a stake in a customer in order to assure future revenue. Nvidia is locking OpenAI into a long-term relationship that provides stable demand for years to come. OpenAI is trading equity for access to the most sophisticated AI chips on the market.
Both of these developments should be monitored closely in order to gauge the overall health of the AI thesis. However, we think investor emphasis will shift in 2026 to profitability and not just further massive investments in capex. When will companies show evidence that their investments are paying off? Microsoft and Amazon are already showing their capex expenditures are starting to bear fruit. Meta is still a question mark.
There have been three episodes so far in 2025 where AI stocks have sold off as a result of the bears crying “bubble.” This will probably continue. AI investors will have to tolerate volatility in share prices at times as the price of participating in the greatest technology invention since the birth of the internet.