Weekly Warm-up: The Signals Through the Noise
While the S&P 500 has made little headway since early June, a lot has changed under the surface with a rotation from early to mid cycle winners and toward quality. This shift is consistent with a broadening given the S&P's dominant quality weight and the strength in earnings across the index.
- The index does not tell the whole story of 2026. Beneath an S&P 500 that has made limited headway since early June, leadership has changed materially. The early-cycle, capital intensive trade has given way to a mid-cycle rotation toward quality, strong free cash flow, AI adopters and asset-light/services businesses. We see this as the primary trend heading into the fourth quarter, and it informs our relative preference for quality stocks, Financial Services and AI adopters.
- Strong nominal GDP and earnings growth continue to offset falling valuations. The market has been able to absorb multiple compression back to the March lows of 19x for the S&P because the earnings backdrop remains so resilient: median Russell 3000 EPS growth is running in the mid-teens, while S&P 500 earnings revisions are again approaching prior-cycle highs. This is the mid-cycle playbook—earnings growth, rather than multiple expansion, is doing the heavy lifting.
- Momentum is ripe for a comeback—but with different constituents leading. We view the recent momentum unwind as a symptom of the transition from early to mid cycle and from AI enablers to adopters, not simply a positioning event. As momentum rebuilds, we expect the long leg to increasingly feature services-oriented, asset-light companies with strong free cash flow—Software, Financial Services, Insurance and Healthcare Services are likely to be more heavily represented.
- Higher oil and rates remain the main risks to equities in the near term. Strong nominal growth—Q2 nominal GDP was 8% annualized—along with elevated issuance and volatility in the war and oil markets has pushed long-end yields higher, with little evidence that fiscal sustainability concerns are the primary driver. A renewed rise in oil could add further pressure to rates, which would be a near-term risk for equities. Our "Run It Hot" thesis is alive and well but these are the risks that will ebb and flow.
The Signals Through the Noise
Year-to-date, the major US stock indices are up double digits, already putting them on track for another strong year of returns. In fact, this is one of the broadest year of returns in recent memory, with the S&P 500, Dow Industrials, Nasdaq 100, Nasdaq Composite all up between 13-16%, and the Russell 2000 up 20%. This is in contrast to the past few years, when returns were narrower and more concentrated in large cap AI-related stocks, especially the enablers (a.k.a the picks and shovels). In line with our outlook for this year, market performance has broadened driven by earnings growth. EPS growth for the median stock in the Russell 3000 is currently running in the mid-teens, which is driving a much broader return profile in the US stock market ( Exhibit 1 ). This has all coincided with what we have deemed a new economic cycle that began at the trough of the rolling recession around Liberation Day in April 2025. The reacceleration in sales growth has led to a v-shaped rebound in EPS growth as operating leverage returned to the median company. This was a classic early-cycle dynamic that has supported our primary thesis over the past year, which remains out of consensus—i.e., a new economic and earnings cycle began in April of last year.
In June, we anticipated the peak rate of change in earnings revision breadth for Semiconductors, which had reached extreme levels, another characteristic of an early-cycle recovery. Semis revisions have bounced slightly since, but are not on the verge of reclaiming prior highs like overall S&P 500 revisions. Shortly after our call on Semis in early June, we made the case that market internals were moving from early cycle to mid cycle. This shift was supported by our factor work which showed a clear transition to higher quality leadership led by strong free cash flow factors. The last time we experienced this rotation was in April 2021 which was also a period that coincided with a maturing earnings cycle and a less dovish Fed.
This has also led to a performance and EPS revisions shift away from asset-heavy industries to asset light ones as the market began imposing more scrutiny on capital spending. As Exhibit 6 shows, services (less capital intensive) industry groups have seen recent strength in earnings revisions breadth, which points to a catch up in performance. Software, Financial Services, Insurance, Healthcare Services have led in this regard. We disagree with those claiming that nothing has changed fundamentally in terms of market leadership, and that the momentum selloff was simply a repositioning of overleveraged portfolios. We think this transition to mid-cycle is what drove the repositioning, which was then exaggerated by the leverage. What this means is that momentum can re-emerge as a leading factor, but the constituents in both the long and short legs of the momentum factor have changed. As our recent work shows, services-oriented industries with strong free cash flow are likely to make their way into the long leg of price momentum.
In line with our views, index upside has been driven by earnings strength as opposed to multiple expansion, which is another hallmark of a mid-cycle period. As Exhibit 8 illustrates the S&P 500 is flirting with all-time highs, while the market multiple just recently tested the March lows. When we look at the entire year, we notice there have been three very distinct periods, beginning with the first quarter, when stocks performed poorly overall as the Iran conflict unfolded and there were questions around the ROIC of the AI spending boom. During the next period between March 30 and June 2, the market narrowed considerably around the AI spending beneficiaries as the AI model companies illustrated tremendous revenue growth and oil prices fell sharply from their initial spike. The final period shown in Exhibit 9 is since June 2, when the market began to contemplate the peak rate of change on earnings revisions (particularly for Semis) and the transition to mid-cycle. In line with our comments above, notice how leadership in this most recent period is concentrated in asset-light and services industries including Financials, Healthcare Services, Commercial and Professional Services, as well as Software. See here, here and here for more on why we think this leadership transition is about more than just positioning and is tied directly to the mid-cycle rotation as the market prioritizes free cash flow, operational efficiency and capex discipline.
For regular readers, they may find it interesting that semiconductors continue to follow our silver stock analog almost perfectly. It currently suggests one last bounce before new lows this fall ( Exhibit 10 ).
From here, we stick with our quality rotation call. Importantly, this is consistent with our broadening thesis as the S&P 500 is a quality-dominated index (>40% weight in our highest quality quintile). As shown above, the earnings recovery continues to broaden. This supports a US over international equity bias. We also favor AI adopters over enablers as the technology diffuses throughout the economy. Financials broadly offer a compelling risk/reward across Insurance, Capital Markets and large cap Banks as loan growth improves, capital markets activity continues to accelerate and the sector benefits from AI adoption. Favor Life Insurers over P&C given favorable mortality trends, improving variable investment income headwinds, moderating spread pressure and strong retirement demand.
Finally, from a risk standpoint, we continue to think macro concerns present the biggest obstacles in the short term. More specifically, we are focused on the recent break higher in long-end rates, which is a function of 1) strong nominal growth; Q2 nominal GDP growth was 8.0% annualized, 2) oil/energy markets, and 3) excess supply from both sovereign and corporate issuance, and is less about the fiscal sustainability/dollar debasement concerns that have arisen following Treasury's announcement of increased buyback sizes, in our view. As noted in our recent reports, the evidence of clear concern about fiscal sustainability in the market is absent when looking at the term premium, which remains contained relative to history. Instead focus on nominal GDP growth as the main driver as it is more than 200 bps above the current 10-year UST yield, in addition to elevated issuance.
We do think the new Fed chair also plays a role here as he tries to build credibility with respect to the Fed's commitment to bring inflation back to target and given his distaste for using the Fed's balance sheet outside of true emergencies. This may include his lack of support for financially repressing bondholders in the face of such strong nominal GDP growth, as has been the case over the past 15 years. These factors could drive yields higher in the near term as markets test his resolve, which would present a risk to equities broadly in the short term should this play out.
Secondarily, but also related to rates, is the risk of oil prices rising sharply again. It is well understood now that strategic reserves have been drawn down substantially to cushion oil prices, given the reduction in flow through the Strait of Hormuz. However, this has not prevented product prices from remaining near all-time highs, particularly diesel. At some point, that spread should narrow, which could occur through rising oil prices more than falling diesel prices. In that case, rates are likely to rise further, which would be a short term risk as noted above, should it play out.
Finally, the Japanese Yen is showing newfound strength the past days. Should this accelerate, it could lead to some deleveraging of equity positions globally.