[00:00.4]
All right, we appreciate you all taking the time to be here. Second quarter gave us plenty to talk about. Markets navigated tariff uncertainty, shifting expectations around interest rates and Fed interest rate strategy and policy, ongoing political developments, and another strong earnings season.
[00:17.4]
Despite some volatility along the way, the economy continued to show resilience, reminding us why it’s so important to stay focused on long term fundamentals rather than short term headlines. So with that, I’ll turn it over to Nathan to walk through what drove markets during the quarter, how portfolios responded, and what we’re watching as we head into the second half of the year.
[00:37.4]
Great. Thanks, Troy. Appreciate everyone coming out today. As Troy said, my name is Nathan Davis. I’m a partner here at Aspen, as well as our chief investment officer. And I do get, I do enjoy getting to provide these updates on a quarterly basis.
[00:57.3]
Even, even now, this year, kind of kicking myself. I spent a few years complaining that markets were just going up and it was so boring and not much was happening post Covid. And I think I have learned to never complain about that again because we’ve had a good year so far.
[01:12.3]
But at least it’s been a little interesting. It makes preparation for these, a little bit easier when, when we have some interesting market developments and we get really great client questions, that allow us to kind of formulate a good presentation here to try and summarize and explain what’s been going on with markets overall.
[01:33.9]
And so we’re going to take some of those questions, and make that the backbone of our presentation today. So, while there’s been no shortage of important economic, political market developments, overall, not every headline deserves equal weight.
[01:49.6]
Not every, not every change in the data requires a change in an investment portfolio. So today we’re going to focus, on what we would summarize as three questions that we believe matter the most for investors right now. And a lot of this comes from, you know, client, direct client questions we have of how we summarize it into, into three direct questions.
[02:09.6]
So the first one is, you know, is the economy cooling or is it breaking? And I’m not one for building suspense. To answer that question, we feel that our current view is that, yeah, the economy is definitely cooling. We don’t think it’s breaking. We want to look at these questions here.
[02:25.6]
I want to provide you what our summary is going to be. It helps give some context when we look at all the supporting data. You’re not, you know, waiting for a hook at the End of like, hey, what are the answers to these questions? You know, we think overall that the economy is cooling, but it’s not necessarily at a breaking point.
[02:40.8]
You know, growth has become less balanced. Labor markets definitely started to soften. We’re not seeing the broad contraction that would normally be associated with a recession, you know, but we’ve definitely seen some cooling down second after, after the markets rebound, from a pretty tough first quarter.
[03:02.0]
Are stocks now too expensive to keep owning? And our, our answer to that is stocks remain expensive. They’ve been expensive for several years now. But in no way, shape or form does that mean that stocks are uninvestable. Valuations leave less room for disappointment.
[03:19.1]
But neither elevated prices nor record highs are reliable reasons to abandon a long term equity allocation. We’ll unpack that a little bit with a few, data points. And then third, where are investors being paid today? You know, when we take all of this data, the economic updates, the reviews of what markets have done, we always try to tie it back like, well, as investors, what does that actually mean for you and your portfolio?
[03:44.6]
And we believe that overall the opportunity set has broadened. Bonds are once again offering meaningful income. International markets and a wider range of companies are contributing to global equity returns after quite a bit of concentration of return providers, over the last several years.
[04:05.1]
And so we want to give you these conclusions up front and then work through the evidence behind them, you know, the risks that could change our views and more importantly like what this means for portfolio. So let’s begin with a quick look, what markets actually did during the quarter, on a short term basis, before we get into the economic headlines and all the reasons, you know, let’s just look at the scorecard of what actually happened.
[04:30.3]
So second quarter was an exceptionally strong period for global stocks. So US stock market overall gained just over 15%. International developed markets gained approximately 10. And then emerging markets were the strongest major asset class, rising a little over 24% overall.
[04:51.9]
Global real estate also participated. It gained nearly 11%. That was a first compared to the last couple years, right along with bonds, global real estate have struggled a little bit with the rising, the new higher rate environment. And although the returns were a lot more modest, you know, US and global bond markets finished the quarter in positive territory.
[05:13.6]
So there are two things that I would emphasize about these results. First is that the strength was not confined to the largest American technology companies. And that’s what when I said, hey, We’ve seen some differences. That’s a primary1. US stocks had an excellent first quarter, but emerging markets performed even better.
[05:32.1]
International developed stocks generated double digit gains, and then real estate participated as well. Even outpacing international developed a little bit. It was a much broader advance than the market environment investors had grown accustomed to during much of the last several years. So second, these were not in any way, shape or form normal quarterly returns.
[05:52.6]
Since 2000, the average quarterly return has been approximately 2.4% for US and emerging market stocks and about 1.6% for international developed stocks. 15% to 24% quarterly gain, is therefore an absolutely unusually strong outcome.
[06:13.5]
That does not mean that these results were unprecedented and it certainly does not mean we should annualize them or expect them to continue at the same pace. You know, the bottom half of the slide reminds us that quarterly stock returns have historically covered a very wide range.
[06:29.9]
Strong quarters and painful quarters are both normal parts of owning equities. Bonds provide us a useful contrast there. They produce positive returns, but nothing comparable to stocks. Domestic interest rates generally rose during the quarter and that limited some of the potential price appreciation, from our bonds.
[06:51.3]
But the income that was earned on those bonds, which is now at a, you know, a new kind of higher baseline rate, which we’ll talk about more later too. The income earned on bonds helped keep things, you know, positive overall for the bond market. So the, you know, the, the headline from this slide is straightforward.
[07:09.3]
It’s that, the second quarter was unusually rewarding. And those rewards were spread across a much broader range of global assets than simply the US Mega cap companies that have dominate many recent conversations. But one unusually strong quarter can easily distort how we perceive the broader investment experience.
[07:30.0]
And we’ve seen that play out, you know, this month starting a new quarter where, you know, global stocks overall are fluctuating. They’ve given back some of the returns of the, of the second quarter at times, they’ve fluctuated back and forth with being, being roughly flat month to date, quarter to date.
[07:47.8]
And so, you know, using that as context, before we discuss why these markets so well, let’s zoom out a little bit and look at those same broad asset classes, but over periods ranging from one year to 20 years. And so, you know, longer into shorter term to midterm returns for all these same asset classes.
[08:11.7]
The most important lesson is that the story changes considerably depending on where we place the starting line. Over the most recent year, emerging markets were the clear leader, returning approximately 43.5% percent. U. S stocks returned nearly 23% and then International developed returned about 21.
[08:31.4]
Those are absolutely exceptional one year equity returns across all three of those major regions. When we extend the period, the picture changes. In over the last 10 and 15 years, the US market has been the dominant performer.
[08:46.9]
U S stocks earned approximately 15% annually over the past decade, and almost 14 annually over 15 years. Those results were substantially stronger than international developed and emerging markets over the same periods. And so that long period of US Leadership has understandably shaped investor expectations.
[09:08.7]
It can begin to feel as though the United States, particularly the largest growth companies in the United States, are simply destined to outperform forever. But the most recent quarter, and year, they provide an important reminder that leadership can change.
[09:25.9]
Sometimes that leadership can change quickly. Emerging markets led this quarter. And over the past year international developed markets have been very strong, as well. And an investor who abandoned those markets after years of disappointment would have missed a meaningful part of the recent advance.
[09:44.0]
And so this is absolutely one reason that diversification can be frustrating. We usually know which investment we wish we had owned only after the returns have occurred. Diversification means accepting that some portion of the portfolio will almost always look less impressive than the current leader.
[10:05.2]
The bond figures here also deserve some context. The five year annualized return for the US bond market is nearly zero. That tells us how difficult the period beginning around 2021 was when interest rates reset sharply higher in those existing bond prices declined.
[10:23.1]
Those trailing returns only tell us where the asset class has been. However, they do not necessarily tell us what it offers today. The same increase in yields that hurt prior bond returns have created a much more attractive starting, income point for future bond investors.
[10:39.4]
So what you buy today and what you hold into the future, we’re going to return to that later in the present. So I would not use this chart to declare a permanent winner from an asset class perspective. I would use it to draw in fact the opposite conclusion, that different markets lead over different periods.
[10:58.5]
Leadership is difficult to forecast and the disciplined portfolio should not be redesigned simply by looking backward at whichever column currently has the highest number in terms of, highest return number in terms of past returns.
[11:16.4]
So with that, with that longer term perspective established, we can turn to one of the quarter’s most dramatic stories and that’s the, you know, the sudden oil price shocks that we have seen not only over the past quarter. But extending back into the end of the second quarter as well, the effect it had on households and inflation and then overall the you know, rapid reversal that followed and just the ongoing volatility.
[11:43.0]
So you know, one of the clearest examples this quarter of a geopolitical event reaching the everyday economy was the sharp movement that we’ve seen in oil and gasoline prices. Conflict, with with Iran raised concerns about global production, shipping and access through the trade Hormuz.
[12:02.2]
Those concerns pushed oil and gasoline prices higher. When tensions ease, prices fell. When the conflict intensified again, they moved back up. There tend to be a pretty rapid following in those prices, as headlines, as headlines hit on, oh there’s a piece of steel, the piece deal is off, negotiations are falling apart.
[12:22.1]
Tends to be a pretty rapid response in oil markets. And so the, the left side of the chart here, it translates that oil market volatility, into what we all as consumers actually experience at the, the gas pump. Gasoline prices matter, for more than simply the amount households spend filling their cars.
[12:41.4]
They’re among the most visible prices in the economy. So people see them displayed on signs every day, which means they can influence consumer confidence and inflation expectations much more quickly than many other price changes. However the, the upper right portion of the chart here, it shows why today’s economy is less vulnerable to higher oil prices than it was during something like the, the oil crises, 1970s.
[13:08.4]
The United States is now a net exporter of petroleum and related products, equal to approximately 0.3% of GDP in the first quarter. In previous decades, higher oil prices primarily transferred income away from the American consumers and businesses to foreign producers.
[13:27.4]
Today those, those effects are a little bit more mixed. Consumers, airlines, transportation companies, and other energy intensive businesses, they still pay more. But American oil producers, their employees, those energy producing regions also receive additional income thanks to those higher prices.
[13:48.2]
So it does not mean that higher oil prices is harmless. It means they redistribute income within the US Economy rather than acting entirely as a national tax paid to overseas producers. The lower right portion of the slide shows why the household impact remains important.
[14:08.2]
Energy costs consume about 17% of income for households in the bottom income quintile. So the bottom 20% of earners, that falls to approximately 10% for the next group and less than 3% for households in the highest income quintile.
[14:27.1]
So for a higher income household, another dollar at the gas pump may be frustrating, but it’s very manageable for a lower income family. Higher Gasoline, electricity, natural gas bills, they can crowd out spending on groceries, clothing and other necessities.
[14:43.2]
So the economic effect here is very uneven. The country may be better protected from an oil shock in the aggregate, but many individual households are definitely still feeling considerable pressure thanks to the rise in prices at the pump. The encouraging development is that markets have generally treated the oil surge as a temporary disruption rather than the start of a lasting energy shortage.
[15:08.7]
The repeated reversals also illustrate why geopolitical events, are extraordinarily difficult to trade. We’re not big on market timing. I, would say that that further very much extends to something like geopolitical events or earnings events or whatever it may be.
[15:27.2]
Because the same headline that sends oil sharply higher can be followed days later by negotiations, a ceasefire, a, change in supply expectations that then subsequently sends prices back down. The broader lesson is that oil remains a meaningful risk to inflation, household spending and confidence.
[15:49.2]
But predicting each turn is much less reliable than maintaining a diversified and disciplined portfolio. And because gasoline is such a visible and unevenly felt expense, its influence can extend well beyond the actual dollars spent.
[16:05.4]
It can shape how consumers feel about the entire economy. Which brings us to our next point on consumer sentiment. So the oil shock we just, discussed, it did not affect everyone equally. Higher gasoline prices, persistent inflation, elevated borrowing costs and political uncertainty all influence how households feel about the economy.
[16:29.2]
As this chart shows, consumers feel, currently feel quite poorly. Consumer sentiment is not very high at the moment. The University of Michigan Consumer Sentiment index stood at 49.5 in June, compared with a historical average of approximately 77.
[16:48.6]
And so that is an unusually pessimistic reading, particularly given that unemployment remains relatively low and the stock market has produced positive results. And that apparent contradiction is important because consumer sentiment and the stock market are measuring different things.
[17:09.2]
Consumer surveys largely reflect what households are experiencing right now. Gasoline and grocery prices, mortgage rates, concerns about employment, political frustration and uncertainty about the future. Markets, on the other hand, are constantly trying to estimate what corporate earnings, interest rates and economic conditions may look like six, 12 or 18 months from now.
[17:34.8]
And so that means that markets can begin recovering while consumers are still deeply uncomfortable. In fact, recoveries often begin before the news starts feeling reassuring. Because prices respond to changes in expectations, not only to whether current conditions are good or bad.
[17:56.0]
The historical turning points on this chart illustrate that pattern. So, following identified, troughs in consumer sentiment, the S P 500’s subsequent 12 month return averaged approximately 24%. Following sentiment peaks when People are feeling the best.
[18:16.0]
It averaged less than 5%. And so we, we should be careful with that statistic. This chart is not telling us that every low sentiment reading marks the bottom of the market. And we do not yet know whether the current reading represents a true trough in sentiment.
[18:32.9]
Sentiment can remain weak for a long time. And occasionally pessimistic consumers are correctly anticipating worsening economic conditions. The more useful lesson in that feeling pessimistic does not necessarily create an attractive market timing signal.
[18:50.1]
By the time concerns are widely understood and reflected in surveys, markets may have already incorporated much of the bad news. So rather than using either strong market returns or weak consumer confidence as our guide, we need to look beneath the headlines at the underlying economic evidence.
[19:09.0]
And so that, that brings us back to the first question that we teased in the very first slide here. And that is, is the economy cooling or is it breaking? Our answer is that the economy is cooling and it’s becoming less balanced.
[19:25.5]
But we do not yet see the broad contraction normally associated with a, recession. And so to explain why, we will look at four areas. We’ll look at economic growth, business investment, employment, and inflation. We will then bring those pieces together to explain, the Fed, the Federal Reserve’s current, current dilemma.
[19:48.2]
And I’ll say we, you will be able to, check me on this very quickly because I believe it’s tomorrow morning that GDP numbers come out and inflation comes out. So we’ll see how, well any of these conversations we’re having even age and Fed meets later today or the press conferences later today.
[20:07.1]
So back to our. Is gdp, is the economy cooling? Is it breaking? What we’re going to look here is that economic growth remains positive, but, it’s also uneven. So the broadest measure of the economy is our gross domestic product.
[20:23.5]
Real GDP grew at a 2.1% annualized rate during the first quarter. And on the surface that looks relatively normal. It is very close to the economy’s average annual growth rate of approximately 2.2% since the year 2000.
[20:41.3]
But the overall number does not tell us whether growth is broad and whether it’s durable. For that, we need to look at the actual underlying components of GDP. So consumer spending represents approximately 68% of the US economy and has historically contributed about 1.7 percentage points to annual growth.
[21:05.4]
In the first quarter, however, consumption, consumption contributed only 0.4 percentage points. That does not mean that consumers stopped spending. It means that their contribution to growth was substantially weaker than Normal.
[21:21.1]
So higher prices, elevated borrowing costs, and then more cautious household sentiment have all restrained the pace of spending overall. Residential, investment was another area of weakness, subtracting 0.3 percentage points from growth.
[21:39.5]
That is consistent with what we continue to see in housing. Mortgage rates remain high, affordability remains strained, and then both buyers and existing homeowners have, have reasons to remain in place. Net Exports also subtracted 0.4 percentage points.
[21:57.1]
Trade and inventory figures can be volatile from one quarter to another, so we should be careful not to treat every movement in those categories as if it’s a lasting trend. The strongest contribution came from business fixed investment. And although business investment represents only about 13% of the economy, it added 1.4 percentage points to first quarter growth.
[22:23.2]
That was more than three times its average contribution since the year 2000. Government spending also added 0.7 percentage points and then, changes in private inventories contributed another 0.2. So that 2.1% headline is encouraging, but the composition is less balanced than what that headline might suggest.
[22:46.2]
Consumption and housing were relatively weak while business investment and government spending carried an unusually large portion of the load. And that overall is why we describe the economy as cooling rather than breaking. Our output is very much still growing.
[23:04.3]
Some of the economy’s largest and most interest sensitive areas have absolutely lost momentum. The question is whether the unusually strong business investment contribution can persist. If that’s our largest contributor and it is a trend that is unsustainable, can we rely on it to persist?
[23:24.3]
One major reason it’s been so strong is the extraordinary capital spending boom surrounding artificial intelligence surrounding AI. And so to understand, understand why business investment has contributed so much, we need to appreciate the scale of the AI infrastructure build out.
[23:44.4]
Because AI investment is supporting our economic growth at the moment, the AI discussion is often framed as a debate about technology stocks. But the scale of investment has become large enough to influence the broader economy. Hyperscalers, which is relatively new term, but hyperscalers are the companies that are building massive digital infrastructure that power cloud computing and AI.
[24:11.1]
Overall, the left side of this chart shows capital expenditures from five of those major hyperscalers, which would be Alphabet, Google, Amazon, Meta, Microsoft and Oracle. In 2019 their combined capital spending was approximately 71 billion.
[24:31.4]
By 2025 it had risen to about 416 billion. And then consensus estimates place that figure near 771 billion in 2026, approximately a trillion dollars in 27 and almost 1.1 trillion by 2028.
[24:51.7]
So that’s an extraordinary increase in a relatively short period. And this spending does not remain within those five corporate headquarters. It flows through data center construction, semiconductors, computer equipment, networking infrastructure, cooling systems, electricity generation and transmission engineering, and a wide range of all of these supporting industries.
[25:17.2]
And that helps to explain why business fixed investment contributed so heavily to GDP growth on the previous slide. The AI buildout has provided a meaningful offset to softer housing and more modest consumer growth. The right side of our chart here, it adds an important distinction from some of the previous investment booms.
[25:38.9]
These companies generally produce substantial operating cash flow. So much of the spending is being funded internally rather than through, you know, fragile balance sheets or speculative borrowing. It, so much of it is coming from their actual heavy, heavy cash flows.
[25:57.8]
And, and that does not, not eliminate the risk associated with these companies. As capital expenditures rise, the gap between operating cash flow and capital spending starts to narrow. And that, that can place pressure on free cash flows.
[26:13.4]
At some point investors are going to require evidence that this infrastructure produces sufficient revenue, that it produces productivity improvements and eventually long term return. But for this section, the immediate economic conclusion is that AI investment is real, it’s very large and it’s currently supportive of our economic growth.
[26:40.1]
It’s, it is also unusually concentrated. An economy that is relying heavily on one investment cycle. That economy may continue growing, but it becomes more exposed to any slowdown in that cycle. So this chart for us, it strengthens both sides of our conclusion.
[26:58.5]
It helps to explain why the economy has not broken. But it also reinforces why the current expansion is less balanced than that very normal average headline GDP number may suggest. So while business investment remains exceptionally strong, the labor market is sending a clearer signal that the economy has lost some of its momentum.
[27:24.8]
And that is because the labor market growth is very much slowing. Labor market provides some of the clearest evidence that the economy is cooling off. On the left June payroll growth was only 57,000 jobs, while the three month moving average slowed to 111,000.
[27:45.3]
Those numbers remain positive, but they are substantially below the pace that we’ve seen earlier in this expansion. That matters because payroll growth tells us how willing businesses are to add employees. Slower hiring can eventually affect household income, consumer confidence and spending.
[28:04.1]
But the right side of the chart prevents us from drawing an overly negative conclusion. The unemployment rate remained at 4.2%. This is well below the 30 year average of 5 1/2%. And a 4.2% unemployment rate is not a level that is generally associated with a recession.
[28:26.9]
Wage growth among production and non supervisory workers was 3.4% which is slower than it was during the post pandemic labor shortage, but it’s still positive. This creates an unusual distinction between a labor market that is not especially strong and one that remains relatively tight.
[28:48.9]
Companies are hiring fewer workers but they are not yet laying off existing employees in large numbers. So employers may be reluctant to expand their payrolls, because demand is uncertain, you know, financing costs are high, productivity is improving, but at the same time, you know, the labor supply growth has slowed, meaning fewer new jobs may be required, simply to keep unemployment stable.
[29:14.8]
So that is why you know, one week payroll report does not establish that a recession has begun. But dismissing the slowdown because unemployment remains low would also be a mistake. And that’s why we look at the, the combination here.
[29:29.9]
Payroll growth, unemployment, wage growth, hours worked, layoffs, and how broadly job creation is distributed across several industries. So for now the evidence says that hiring has cooled meaningfully but the labor market has not broken.
[29:47.3]
There’s also a connection to inflation here which we’ll cover next. So slower wage growth reduces the risk of a wage price spiral and may eventually give the Federal Reserve greater flexibility. But if, if softer hiring becomes widespread, layoffs, the Fed’s employment mandate, that they have right alongside the managing of prices and inflation, the Fed’s employment mandate would become much more urgent than it is today.
[30:17.7]
It’s rarely even a talking point today. That is one of the primary risks that we’re monitoring going forward. A gradual slowdown is consistent with a soft landing. A rapid rise in layoffs and unemployment would cause us to, to reassess that view.
[30:33.5]
So softer hiring would normally strengthen the case for lower interest rates. The complication is that the inflation picture remains mixed. Beneath the headline inflation really has improved. And you know, obviously beneath the headline, this chart is helpful because inflation is not one single price.
[30:55.5]
It’s the combined result of many different categories in those categories, do not all behave in the same way. In May headline CPI, reached 4.2% year over year. By June it had fallen to 3.5%.
[31:13.9]
Core, CPI which excludes food and energy declined from 2.9% to 2.6%. That still remains above the Federal Reserve’s 2% objective. But the improvement in core inflation is meaningful.
[31:30.6]
The colored areas here show where inflation is Coming from, during the inflation surge of 2021, 2022, the pressure was very broad. Energy goods, shelter, automobiles, insurance, food and services were all contributing at the same time.
[31:49.7]
That breadth made inflation much more persistent and much more difficult for the Fed to control. The current episode is very different. Energy has accounted for a much larger part of the renewed headline pressure. While shelter inflation has continued to cool gradually.
[32:07.4]
And then core goods inflation has remained relatively contained. This distinction matters because an increase in the price level is not necessarily the same as an ongoing inflation process. An oil shock can make gasoline, transportation and energy intensive goods more expensive.
[32:25.4]
Expensive tariffs can raise the price of imported products. But, when those prices rise once and then they stabilize, their year over year effect eventually fades. Persistent inflation requires something more. Businesses repeatedly raise prices across unrelated categories.
[32:45.1]
Employees demand higher compensation to keep pace. Those wage costs feed into services and households begin to expect inflation to remain elevated. That second round process is what the Fed wants to avoid. So we should not dismiss the 3.5% inflation headline.
[33:04.7]
Energy and tariffs can affect household budgets, inflation expectations and corporate profit margins. But we also should not assume that every increase in headline CPI means the broad inflation problem of 2022 has returned.
[33:20.4]
The indicators we will watch most closely are the breadth of price increases, shelter wages, services and longer term inflation expectations. So for now, the inflation details are more encouraging than the headline alone.
[33:36.0]
But they’re not strong enough for the Federal Reserve to declare victory. And, and that brings the the growth employment and inflate inflation evidence. Together, the Fed is looking at an economy that is slowing, but inflation that remains too elevated to ignore.
[33:53.1]
And so the Fed is forced they have to balance inflation and employment. This slide brings together the different signals we’ve just reviewed. The Federal Reserve has two principal objectives. Stable prices, maximum sustainable employment.
[34:08.7]
Right now those objectives are pointing in somewhat different directions. The June economic projections anticipated real GDP growth of 2.2% for 2026 and unemployment rate of 4.3%. Neither number suggests an economy in severe distress.
[34:26.5]
The same projections have showed headline PCE inflation of 3.6 and core PCE inflation of 3.3, both of which are well above the Fed’s 2% target. Employment therefore argues for, caution about keeping policy too restrictive, while inflation argues against easing prematurely.
[34:47.5]
The interest rate projections illustrate that tension. Both policymakers and financial markets expect rates to move gradually toward a lower long run level. But neither anticipates a rapid return to the extremely Low rates investors became accustomed to, during the decade after the financial crisis.
[35:06.9]
Anyone who tells you that they’re waiting for the mortgage rates to get in the low threes to twos again before they can refinance or buy a house, I, I would like to think they will be waiting forever. So it’s, it’s tempting to view a Fed that remains on hold, as uncertain or indecisive.
[35:25.2]
And I would, I would frame it differently. I think holding rates steady preserves their flexibility. The Fed can observe whether weaker hiring turns into layoffs, whether the energy shock fades, whether tariffs create only a one time goods price adjustment, and whether the improvement in core inflation continues to.
[35:43.3]
If labor weakness broadens materially, rate cuts become easier to justify. If inflation spreads into wages, services and expectations, rates may need to remain high or potentially move higher. And so for investors, the important lesson is not to build a portfolio around one precise forecast of the next Fed meeting.
[36:04.0]
Markets already attempt to incorporate the expected path of policy into bond yield, yield stock valuations and currency prices. A resilient portfolio should be capable of functioning across several plausible outcomes. And that’d be, you know, rates remain elevated because inflation proves sticky.
[36:21.3]
Rates decline gradually as growth and inflation cool. The Fed responds more aggressively if the labor market deteriorates and rates rise again if inflation becomes broad and persistent. Our conclusion after looking at all four areas is still that the economy is cooling, but it is not breaking.
[36:39.7]
Growth remains positive, business investment remains strong and unemployment remains low, but consumption is less robust, housing remains constrained and hiring has slowed and inflation prevents the Fed, from providing us with an easy policy response.
[36:55.2]
The evidence is mixed, but mixed is different from recessionary. A cooling but still growing economy can continue to support corporate profits, profits. The more difficult question is how much of that resilience in future growth investors are already paying for.
[37:12.1]
And so that, that’s going to bring us to our second question. You know, after the markets rebound, are stocks now, too expensive to keep owning? And our answer is that stocks are expensive but they’re not uninvestable. And that, and that distinction I think really matters.
[37:29.7]
An expensive market generally offers a smaller margin for error, and it may produce more modest long term returns, but it does not tell us when the market will decline and it does not automatically mean that investors should reduce or abandon their equity exposure.
[37:48.1]
To evaluate the market today, we need to look at what is supporting earnings, how demanding, current expectations have become and then how concentrated the index remains and then what history Tells us about investing near record highs.
[38:05.1]
So, what we’re looking at here is that AI is a genuine earnings theme, but it represents a very large and increasingly varied portion of the market. We’re, you know, when we’re shifting the lens from the economy to the stock market here, the AI theme is much broader than five large technology companies.
[38:27.3]
This chart divides it into hyperscalers, Semiconductors, hardware, and then power related businesses, and software. Together those categories represent almost 50% of the S&P 500, after adjusting for companies that appear in more than one group.
[38:44.8]
And so what that means is now roughly half of the index is now influenced either directly or indirectly by the development and adoption of artificial intelligence. The largest individual category is semiconductors, at approximately 17% of the index index.
[39:02.0]
The hyperscalers represent about 16%. Hardware roughly 11% and then software close to 8%. And power related businesses are nearly 3. And that, that breadth is important because AI is not one homogeneous investment.
[39:20.5]
As I think we’re all a little bit guilty of pointing to it as like, oh, it’s AI. A semiconductor company that’s manufacturing advanced against chips has a very different business model from a software company that’s attempting to add AI features to an existing product.
[39:37.0]
A utility that is supplying electricity to a data center has different economics from a hyperscaler that is building the facility. Some companies sell the infrastructure, some purchase it, and then others are trying to create products that eventually monetize it.
[39:52.8]
The performance and earnings bars illustrate those differences. So some categories have experienced exceptional earnings growth and strong returns. Others have produced healthy earnings growth while their stock prices declined. And that can happen when investors already have already priced in even stronger results, when valuations contracted, or when the market became less confident about how quickly future, profits would materialize.
[40:18.6]
And that, that overall it’s a critical investing lesson. Because strong earnings do not automatically produce strong stock returns. The return also depends on the price investors paid for those earnings and whether the eventual results exceeded or fell short of expectations.
[40:37.4]
The valuations shown at the bottom of the chart also vary. Consider considerably. Several categories trade near 20 times expected earnings, while hardware trades closer to 29 times. And that’s the summarized in the box, on the, the right side of the right chart, there is no one single valuation that describes the entire AI theme.
[41:02.3]
And so I draw two conclusions from this chart. First is that the AI investment cycle is supported by very real revenue, earnings, capital formation. This is not simply a collection of companies with no profits and no viable businesses.
[41:20.6]
And when we do, I would say it’s, it’s waned over time, but we’ve still heard it a lot. The, like the comparison of, oh, is this, is this AI boom a bubble that is reminiscent of the dot com bubble of the early 2000s.
[41:36.7]
In this first point, you never know if it’s a bubble until after it pops, unfortunately. But where I usually go for the first point on that, is that people were fascinated by the Internet as it was launching in the early 2000s. Pets.com had a whole lot of users and pets.com also had no idea how to translate those users into any form of revenue.
[42:00.6]
And all they did was lose money. And there was really no surprise that pets.com goes out of business and blows up because they never made any money. They never had a path to making money. And this point is entirely different today. Real revenue, real earnings, real capital formation.
[42:18.2]
It’s why I feel that this is very different from the early 2000s dot com. Second, because these AI related industries represent almost half of the S P 500, the index has become highly dependent on the continued success of this investment cycle. It creates opportunity, but it also creates concentration, risk.
[42:37.0]
The right response is not to avoid the theme entirely or to assume every AI related company will succeed. It is to participate while remaining attentive to valuation diversification and the differences between a good business and a good investment at a particular price.
[42:54.7]
For today’s valuations to prove reasonable Strong earnings will need to continue in the current forecasts. Set a very high bar overall. And that’s what we see here. So these earning expectations are exceptionally strong. But much of the forecast depends on further margin expansion.
[43:14.1]
You know what we’re seeing here? The slide explains that investors are expecting companies to deliver. The left side here breaks the S&P 500 earnings growth into three different sources. We have a revenue growth, we have our changes in profit margins and then we have changes in the number of shares outstanding, revenues, the top line.
[43:33.3]
So it’s the amount that companies receive from selling products and services. Profit margin is the percentage that revin of that revenue that ultimately becomes earnings. A company can increase their earnings without increasing revenue. If it becomes more efficient, it raises prices, it improves its product mix or it controls its expenses.
[43:53.6]
And so, the other factor here is that share count also matters. When a company repurchases its shares, which has created plenty of headlines over the last 10 years, the same total amount of profit is divided across fewer number of shares. That increases the earnings per share.
[44:11.2]
When companies issue additional shares, the opposite occurs. Consensus forecasts currently expect S&P 500 earnings per share to reach approximately $351 in 2026. That is an increase of nearly 28%.
[44:27.8]
That is an exceptionally strong expectation. Since 2001, the average annual earnings growth has been closer to 8%. The composition of the forecast is at least as important as the headline number. Approximately 11 percentage points of the expected growth, Is attributed to higher revenue, while roughly 17 percentage points are expected to come from expanding profit margins.
[44:54.1]
Changes in share count, are expected to subtract slightly. But overall, you know, historically, margin improvement has contributed only a small portion of average annual earnings growth. If in the current forecast it is expected to provide the majority.
[45:10.5]
That, takes us to the right side of the chart here, which shows the results. Result, s p500 profit margin is forecast to reach approximately 16.7%, near the highest level in the chart’s history. There are reasonable arguments for margins remaining structurally higher than in prior decades.
[45:28.6]
Today’s index contains more technology, communications and asset light businesses that can generate high incremental profit margins. Automation and AI may improve productivity. Large companies also possess considerable scale and pricing power.
[45:45.8]
But this is still a very demanding assumption. Margins can come under pressure from wages, from energy costs, from tariffs, from financing expenses, competition, depreciation. On these enormous capital investments that we were just talking about, and just the normal process by which profitable opportunities attract new competitors.
[46:09.1]
This does not mean that the earnings forecast is wrong. It means that investors should understand what is required to achieve it. At, lower valuations, companies can disappoint modestly and still produce acceptable returns. At elevated valuations, investors have already paid for a significant amount of future success.
[46:30.9]
The companies must deliver enough of the growth to actually justify the price that we paid as investors. And that is a central tension in today’s market. The earnings foundation is very real, but the expected rate of growth and particularly the expected margin expansion leaves less room for disappointment.
[46:50.8]
That brings us directly to valuation and concentration and how much investors are paying for those, those expected earnings. And how dependent is the index on its largest companies? Alluded to it earlier, and we’ve talked about this probably every market update for the last year or more.
[47:09.3]
The market remains highly concentrated, but elevated valuations are no longer limited to the 10 largest companies. So this, this slide addresses 2 concerns that are often discussed together. Market concentration and market valuation.
[47:25.1]
We’re going to begin on the right side of our chart here. The 10 largest companies now represent approximately 38.2% of the S P 500’s total market value. They also generate approximately 38.9% of the index’s earnings.
[47:42.6]
That is an unusually high level of concentration if you don’t just compare it to the last year. And because it’s very usual, we’ve had this story for the last year too. A portfolio holding in S&P 500 index fund owns about 500 companies.
[47:59.2]
But its results are much more dependent on the largest 10 than the number of holdings might suggest. And there’s an important nuance, however. The earnings share of the top 10 is almost equal to their market value share. So in other words, these companies are not merely large because investors assigned enormous value to these businesses that are producing very little profit.
[48:24.8]
They also generate an extraordinary share of the index’s earnings. And that is one reason that the current concentration is different from a purely speculative episode. Many of the largest companies possess strong balance sheets, high margins and very dominant competitive positions.
[48:44.4]
But that concentration still does matter. If a handful of companies disappoint, the impact on the overall index can be much greater than many investors realize. The left side of the slide here, adds a surprising valuation insight.
[49:00.0]
The 10 largest companies traded approximately 19.6 times expected earnings. The remaining 490 companies traded approximately 19.5 times. That means that the market’s elevated valuation is no longer solely a story about the largest technology companies.
[49:20.3]
The largest 10 and the rest of the index now trade at almost identical forward price to earnings ratios, relative to their own histories. The the comparison becomes even more interesting. The top 10 currently trade at approximately 94% of their historical average valuation.
[49:41.2]
The remaining companies trade at approximately 123% of theirs. So in other words, the largest companies are expensive in absolute terms, but the rest of the market is more elevated relative to its own history.
[49:57.5]
Part of that may reflect the recent broadening of market returns. As investors move beyond the largest companies. Prices rose across more of the index. This changes, but it does not eliminate the concentration argument. It’s no longer sufficient to say that the market is expensive only because 10 technology stocks are distorting.
[50:17.2]
The average valuations are elevated much more broadly now. At the same time, this chart does not tell us that a decline must begin immediately. Valuation is generally more useful for settling for setting long term expectations than for forecasting what will happen over the next next several months.
[50:35.0]
Our conclusion is therefore balanced. The the market is expensive and investors should expect a smaller margin for error. The index is concentrated and portfolio outcomes remain unusually dependent on a small number of businesses. But those businesses also produce substantial earnings and high valuations alone are not a reliable signal to abandon equities.
[50:57.1]
The appropriate response is diversification. It’s disciplined rebalancing. It is not an all or nothing forecast that the largest companies must either continue dominating forever or collapse immediately. The valuation question often leads to a second concern, which is that even when investors are comfortable owning stocks, generally, they worry that buying near a record high means they have already missed the opportunity.
[51:23.3]
And what we’re going to look at here is that a record high describes where the market has been. It does not tell us where it goes next. We’re going to kind of deep dive here because this is absolutely the number one most common question that we’ve been getting, you know, over the last three to four months.
[51:42.3]
So we’re going to do a little bit of extra deep dive here. But it addresses one of the most natural questions that, that investors and clients have after a very strong market advance. And that is if stocks are already at an all time high, isn’t it safer to wait for a better entry point?
[51:59.5]
And that concern is very understandable. An all time high sounds like a description of an expensive or vulnerable market. But the term tells us only that the index is higher than it has ever been before. It does not tell us whether the market is expensive relative to earnings, whether the economy is entering a recession or whether prices are about to decline.
[52:21.4]
Line the left side of this chart shows that the S P 500 since 1950, and it identifies the all time highs that established, what J.P. morgan in their data here calls a market floor, which is an all time high after which the market never subsequently fell more than 5% below that level.
[52:43.9]
Only 31 of all time highs have established a permanent floor. So we should not suggest that markets never decline after reaching a record. They clearly do. 81% of the time. However, 81 of all time highs were followed by another all time high within one week.
[53:05.0]
And that, and that makes intuitive sense. Markets do not usually reach a record immediately. Recognize it and then add that, you know, as a important barrier and just stop strong earnings. Economic growth. Investor demand can continue to carry prices through a series of new highs.
[53:24.1]
The right side of our chart here, it provides the more important Investment comparison from 1988 through 2025 investing at a new high produced an average 3 month cumulative return of approximately 2% compared with 3% when investing on just any other random day at 6 months.
[53:45.8]
The results were essentially equal over longer periods. Returns following a new high were slightly better in this historic sample. Approximately 14 after one year. 29 after two years, 46% after three and 82% after five years.
[54:05.5]
For comparison, if we were investing just on any random day, it produced an average cumulative returns of 12%, 26%, 41 and 76% over those same periods. Now, this does not mean that an all time high is a buy signal.
[54:23.4]
It means that it has not historically been a reliable sell signal. There is a straightforward reason for this. Over time, economies expand, companies retain and reinvest their earnings, productivity improves, and then nominal prices rise.
[54:39.5]
A market that appreciates over decades must continually establish new highs along the way. Waiting for a pullback also creates two problems. First, we do not know whether a decline will occur soon. The market may rise another 10, 20 or more before experiencing the correction an investor was waiting for for.
[54:57.3]
Second, even when a decline occurs, the investor must decide when to return. The news is generally more alarming after prices fall. It’s not more reassuring. Market timing therefore requires two successful decisions. When to leave and when to reinvest.
[55:13.5]
And so none of this makes valuation irrelevant. The previous slide showed that prices are elevated and that should influence our long term return expectations. But valuation and an all time high are different concepts. One compares prices with fundamentals. The other simply compares today’s price with yesterday’s price.
[55:31.9]
So our answer to the question is not, you know, that stocks are cheap or that they’re risk free. Our answer is that they are expensive, but not uninvestable. The risks argue for realistic expectations, diversification and rebalancing. They do not provide a dependable basis for abandoning a long term equity allocation.
[55:52.0]
And so that leads us to wrapping up with our third question, which is, where are investors being paid today? Our conclusion is that the opportunity set has broadened. For much of the last decade, investors received very little income from high quality bonds. You know, large cap growth provided a lot of our returns, but today’s environment definitely looks different.
[56:12.7]
Starting yields. Looking at our fixed income, starting yields are providing a very reasonable estimate of medium term bond returns. Today’s yields are substantially more attractive than they were several years ago. Central point of this chart is that a bond’s portfolio starting yield has historically been a very strong guide to the return investors subsequently earned over the following five years.
[56:36.2]
Each of these dots here represents a historical five year period for the Bloomberg US Aggregate Bond Bond Index. Horizontal axis shows the index’s yield at the beginning of the period while the vertical axis shows the annualized total return over the next five years. Overall the starting yield explains about 89% of the variation in subsequent five year returns.
[57:00.1]
As of July 27th the index has yielded approximately 4.94%. And then based off of the historical relationship here, should be pretty consistent with an annualized five year return of approximately 5%. The reason for this is that relationship is so strong is that most of a bond’s long term returns comes from its income, even if there is some short term price volatility due to interest rate changes.
[57:28.4]
So if interest rates rise from here there could be some near term price pressure. But then investors get to reinvest that income at higher yields, yields, and you know, if rates decline, existing bonds may appreciate it. Although the downside is that future reinvestment income would be at lower rates.
[57:47.4]
So all that is to say is that it does not mean we should make an aggressive bet that interest rates are about to fall. Long term rates could remain elevated because of persistent inflation, you know, because of federal borrowing needs. But you know we do not, you know overall we just, just do not need to see a dramatic rate forecast to justify owning high quality bonds.
[58:10.8]
Our perspective return is already near 5%. And that is a very credible source of return. So in bonds the source of that prospective return is relatively visible because we can observe the starting yield. In stocks, the return is less certain and comes from several different sources.
[58:27.5]
And what we’re going to look here is that recent international returns have been supported by several ingredients. It’s not simply currency returns, it’s lots of components. And we’re going to look a little bit more deeply at the earnings, the dividends, valuations and then for a US investor we’re going to look at currencies as well.
[58:47.5]
It’s similar to our other slide but on a global perspective. This provides us a framework for understanding where global equity returns come from. Total height of each bar represents the return, earned by a US based investor. The different colors here divide that return into four primary components, those being earnings dividends, changes in valuation multiples, and currency.
[59:12.0]
We already covered earnings dividends, prior. But I will say to expand a little bit on something like the multiples, the third component there. So a Forward price to earnings ratio tells us how much investors are willing to pay for $1 of expected return.
[59:33.5]
Or suppose a market generates $100 of earnings and it trades at 15 times earnings. Its value would be approximately 1500 bucks. If earnings remain at 100 but investors become willing to pay 18 times earnings, market rises to approximately 1800.
[59:49.1]
Underlying earnings haven’t changed. Investors have simply assigned those earnings at a higher price. That, that is what multiple expansion means. You know multiples can expand for several reasons. Reasons investors can become more confident in future growth. We have seen a lot of that recently.
[60:06.1]
You know, exuberance around AI and all of the implications it’s going to have for companies and future earnings. If interest rates decline, increasing the present value assigned to future earnings. Political or regulatory uncertainty. There’s, there’s also several reasons that we could see for con for contractions.
[60:26.3]
Rates rising, risks increase, earnings expectations appear to optimistic. But multiple contraction is not always a sign. It’s not always evidence that businesses are deteriorating. A lot of times and we’ve seen some of this lately, you know multiples can contract and prices can still rise.
[60:45.1]
And that is because we, you start to see that in the earnings denominator grow faster than the price. So all of the expected earnings that we’re seeing start coming to fruition. Prices can still appreciate because earnings are growing. Even if the multiple that investors are willing to pay declines in the, in the process there.
[61:07.0]
So you know the, the most important point is that international returns, it was not produced by only one source currency, was a part of the story. But earnings dividends and changes in valuation also contributed as well. You know this, this slide here, it explained where these recent returns earns came from.
[61:24.7]
The next slide is going to address the starting price investors are paying for those future earnings. International markets remain meaningfully less expensive. Although lower valuations reflect both genuine risks and lower investor expectations.
[61:41.4]
And so this, this moves from more so from looking at recent performance to looking at current valuations. The forward PE ratio compared to there’s market’s current price with the expected earnings. We’ve covered that quite a bit. United States is trading at 19.6 times expected earnings.
[61:57.7]
Japan for example is trading at 16 and a half times earning. The Eurozone is at 14.9 times earnings. Broad non US markets at 13.4 times earnings and emerging markets are trading at 10 and a half times earnings.
[62:14.4]
In simple terms investors are currently paying $20 for each dollar of expected US earnings, and with compared with $13.40 for a dollar of non U. S earnings and $10.50 per dollar of earnings in emerging markets.
[62:31.7]
This does not tell us that international markets are going to outperform, but we do see that some of the valuation difference is justified. We know that a large part of those multiples that we’re willing to pay is expectation for future growth.
[62:47.9]
Nowhere else in the rest of the world are they investing in AI the way that we are in the United States. And if you believe that there will be meaningful improvements to earnings, to businesses, to profitability, and productivity, very much that is coming on the back of AI, we do not have a lot of that in the rest of the world.
[63:09.2]
But we also talked about how the, the, the less that you pay today for a dollar of future earnings, the less variable your future outcome is for expected returns. And we do believe that the rest of the world, while looking at the 10 year track record of how the rest of the world has done relative to the United States is very noticeable, we do believe that it is a very valid, landscape for investment today.
[63:39.6]
It provides us attractive purchase prices and it provides us a great deal of diversification outside of only investing in US Markets. So conclusion is we, we’re not going to abandon the United States, we’re not going to make large tactical bets on international markets, but we want to make sure that given the global market portfolio and market cap weightings, that international and emerging markets are getting their due, in, in our client portfolios.
[64:11.7]
So, you know, wrapping up with question three, when we say the opportunity set has broadened, you know, we have fixed income with starting yields near 5%. That is a very credible source of return. Global equities, the leadership has expanded beyond the United States.
[64:29.1]
We have very attractive valuations overseas with still strong earnings, still quality dividends, and none of that requires us to predict the next federal reserve decision, the direction of the dollar, which country will lead over the next year, it all supports a durable conclusion.
[64:46.0]
Investors now have more ways to earn a reasonable return than they did when bond yields were near zero and when market leadership is concentrated almost entirely to the United States. And so looking at what that means for implications for investors, investors so that we can wrap it up, the current environment does not require a dramatic portfolio pivot.
[65:06.6]
It reinforces the value of a disciplined portfolio construction. After working through all three questions, the natural question is like what does any of this mean for portfolios. Our first conclusion is that the current environment does not require a dramatic portfolio pivot.
[65:22.9]
The economy is cooling and becoming less balanced, but we are not yet seeing a broad contraction that would normally accompany a recession. At the same time, stocks are expensive and concentrated. But neither valuation nor all time high gives us a reliable signal of when to leave the market or when to return.
[65:40.0]
And that just supports remaining invested. But with realistic expectations, the unusually strong returns investors have recently experienced should not be treated as a new normal. Elevated valuations being future results may depend more heavily on companies delivering the earnings growth and profit margins that investors already expect.
[65:58.5]
We should participate in that growth without assuming it’ll arrive smoothly or evenly. The second implication is that high quality bonds can once again play a more productive role in portfolios. For much of the period following the financial crisis, bonds provided diversification, but they provided very little to no income.
[66:17.6]
Today’s starting yields are much more meaningful and have historically been a useful indicator of medium term bond returns. High quality fixed income can generate income, provide liquidity and it can help fund planned portfolio distributions without requiring us to sell equities during an unfavorable market.
[66:34.9]
That does not mean that making a large bet on the next interest rate move, it means recognizing that we no longer need rates to fall dramatically for bonds to make a valuable contribution to our returns. The third implication is to diversify into rebound balance.
[66:50.3]
U.S. companies remain exceptionally profitable and innovative and they should continue to represent a substantial part of our portfolios. But The S P500 remains unusually dependent on a small group of companies. While international markets offer different combinations of earnings, dividends, different sectors, currencies, valuation diversification does not require us to predict that international markets will outperform next year.
[67:14.4]
Its purpose is to avoid requiring one country, one theme or 10 companies to remain dominant indefinitely. And rebalancing is how we maintain that discipline. When one part of the portfolio performs exceptionally well, we do not need to predict that it is about to decline.
[67:31.7]
We simply restore the portfolio to the risk level that supports the client’s financial plan. The portfolio response is not to chase what has been recently performing best or retreat when the environment feels uncertain. It’s to maintain the appropriate equity participation while holding meaningful high quality fixed income.
[67:49.4]
And we diversify our sources of return and rebalance around the plan. This portfolio framing is consistent with the source materials emphasis on retaining equity participation while also using high quality fixed income, and allowing for that liquidity in case any sort of weakness starts to broaden it reflects a stronger perspective, from a bond income environment.
[68:11.0]
And then the rationale for diversifying beyond concentrated US Market leadership. So, here’s a one last summary of our final three conclusions where we feel like the economy is cooling, it hasn’t broken. Yes, U.S. stocks are expensive, but absolutely stay the course.
[68:28.8]
They belong in a portfolio and look outside just the United States. The opportunity set has broadened, and we make sure that a well diversified portfolio includes all of the asset classes we discussed there. So, I appreciate everyone for joining us today.
[68:44.5]
Happy to take any questions. Usually we get a few questions after the fact. That’s personal. That’s perfectly fine too. Generally questions are pretty personal instead of general. And so that’s what we’re here for, being able to help navigate all these scenarios. So thank you very much for your time today. Yeah, thanks Nathan, for the great overview.
[69:01.2]
I’m not seeing any questions. This looks like we covered everything we set out to today. But if anything like Nathan said comes to mind after the webinar, please don’t hesitate to reach out. We’d be happy to discuss how today’s topics relate to your specific financial plan. As always, markets will continue to present both opportunities and uncertainty.
[69:20.3]
But our investment philosophy remains the same. Build diversified portfolios grounded in evidence. Stay disciplined through changing market environments, and keep every investment decision aligned with your long term financial plan. So thank you again for spending part of your day with us. We appreciate your time and hope you have a great rest of your weekend.
