Market Commentary

Performance in the equity markets was mixed this week, with the S&P 500 finishing roughly flat. In the bond market, the 10-year U.S. Treasury yield briefly reached 5.34%, its highest level in more than two decades. The upward pressure on long-term yields reflects several factors, including elevated energy prices, persistent inflation concerns, and increased government borrowing.

Inflation and labor market data released this week came in below expectations, reducing the likelihood of another interest rate hike at the Federal Reserve’s October meeting. Annual headline PCE inflation was 3.4%, while employers added just 29,000 jobs in September. Employment gains for July and August were also revised downward by a combined 60,000. Despite the softer data, several Federal Reserve officials have indicated that additional rate increases may still be necessary to bring inflation back toward the Fed’s 2% target. As of Friday, futures markets were pricing in roughly an 80% probability that the Fed will leave rates unchanged in October, while another rate hike by year-end remains possible.

Investment in artificial intelligence remains a significant theme for financial markets, with major technology companies continuing to commit substantial capital to AI infrastructure. This investment is supporting economic growth and equity markets, while also creating significant financing needs. The scale of spending has also raised questions about future returns and the sustainability of current valuations.

“We've never in almost 100 years seen breadth this bad,” said Jason Goepfert at SentimenTrader. “The C Fund is knocking on new highs, but there are many more stocks at lows than highs. The percentage of stocks in long-term uptrends is plunging. The only remotely similar setups were January 1973* and November 1999**.”

*From January 1973 until October 1974, the C Fund declined 47%.

**From Nov. ’99 to Oct. ’02, the Fund fell 43%.

The Wall Street Journal highlighted a Fortune magazine cover from late September 1987: “Are Stocks Too High?” was the question, and “no” was their answer. “New ways of valuing shares give some surprising answers… Clearly, something is going on that the old analytical concepts cannot account for.” Three weeks later, the C Fund fell 20%, its worst single-day decline ever.

Potential breakthroughs in AI and actual gains in corporate profits have fueled the stock market’s boom since late 2022. While AI companies have provoked a backlash of fear and anger, profits have taken the role of the gift that keeps on giving. However, like the duck skimming along a pond, the surface serenity obscures a wild ride beneath.

The AI building boom has accounted for a substantial percentage of national growth in recent quarters. This small sector has generated half the expansion in our $30 trillion economy. Accounting rules have further distorted the picture—namely, a lot of the AI spending provides immediate revenues to sellers, but the matching costs to buyers aren’t reported until future years.

As One Point’s Peter Boockvar summarizes: “We have a US economy that is mainly dependent on this spending orgy and on upper income consumers who, in turn, are highly reliant on a stock market that is hugely hooked on AI and its spending.” So long as AI construction grows from quarter to quarter, the profit cliff remains beyond the headlights. But this ledger legerdemain is unsustainable, particularly in view of the bipartisan revolt against data centers.

The numbers to date are stunning. The capital expenditures from only five companies—Alphabet/Google, Amazon, Meta/Facebook, Microsoft, and Oracle—will top $1 trillion next year, up 400% in three years. Those C Fund companies that are involved in AI infrastructure posted an aggregate 54% profit increase last quarter (vs. 14% for the others in total) vs. 8% for national output.

The primary component in profits is compensation. Since WWII, the percentage of national income that accrued to labor has fallen to an all-time low. Globalization was the primary catalyst for this downtrend. AI might shift more compensation to corporations and less to their employees, or it might not… this is the great unknown. What we do know for sure, however, is that the globalization tide has reversed, and that will put pressure on profit margins.

Margins have also gotten a huge boost these past four decades from lower tax rates and, especially, from lower interest rates. Corporate tax rates won’t fall any further and might get legislated higher. As for interest rates, ten-year Treasury yields have already risen sharply from their 2020 lows:

Though rates look ‘reasonable’ by historical standards, government debt has piled on at a staggering pace since 2000. Moreover, corporations that gorged on low-rate debt five years ago will have to refinance at much-higher rates in the next several years. “Financing a $365 trillion global debt burden at a 5% interest rate will prove to be a tough task,” warns economist David Rosenberg.

The 30-year bond is probably the best gauge of fiscal and monetary fears looking far ahead. The yield here in the United States, as in other countries, is showing a disturbing trend higher:

Another important factor is the disconnect between inflation faced by producers and consumers. The latest numbers have prices paid by wholesalers up 5.4%, a full two percentage points higher than the overall price increases for the public. Either producers will raise their prices more aggressively, driving down demand, or profit margins will contract.

“Price pressures intensified in September,” per last week’s PMI report. “Average input costs measured across both goods and services surged higher, the overall rate of inflation hitting the highest since October 2022.”

We’re already experiencing chaos in global bond markets, with yields across the world at two-decade highs. Japan’s 10-year bond rates are now more than 3%, whereas they were less than zero a decade ago. The finances in Italy and France are particularly dicey. “A crisis always starts in the most vulnerable places and spreads from there,” economist Robin Brooks noted. “That’s what’s happening now.”

Most of the negative influences haven’t hit yet, but they’re on the way. Moreover, if our economy slides into recession should the AI bonanza suffer a temporary bust (as the telecom boom did in 2000–2003), profit margins will plummet. Back then, margins bottomed at 5% versus the current heights of 19%.

The key point here is that profits are at risk even as participants in the stock market are paying an unusually high amount for each dollar of those profits (what Dr. John Hussman refers to as “top dollar for top dollar”). Valuations have never been this extended, even in 2008 or 2000 or 1929. We’ll examine this more closely in our next Commentary.