Acknowledging a Negative Potential Outcome
The outlook for stocks and risk assets remains positive, but if things start to turn bad, the situation becomes downright scary from a return standpoint. So, in honor of the start of Halloween decorating, and because I want to make sure that we all understand what a truly negative scenario for this market looks like, I’m going to describe what a scary, but entirely possible, market environment looks like, so that we understand the stakes heading into the fourth quarter and as we look towards 2026.
Scary situation 1: It is an AI Bubble. This topic has quickly become one of the most popular on Wall Street, but despite rising concerns that we are in some sort of an AI bubble, the stocks just continue to move higher, as do the seemingly daily announcements of billions upon billions of capital investment in AI. As things sit now, there appears to be little-to-no concern about an AI bubble despite some potential red flags.
For instance, The growing number of circular financing arrangements between NVDA and an increasing number of its biggest customers is reminiscent of similar moves by Lucent Technologies and other telecom names in the 1990s. Meanwhile, companies with extreme valuations that seem to be little more than middlemen in the AI cap-ex explosion (CoreWeave and others) do raise some eyebrows, especially because these companies have little-to-no value if exponential compute demand suddenly slows.
Finally, explosive valuations for private AI companies that, as of yet, don’t have any clear path to profitability (especially considering the extreme cap-ex schedules) do require some reflection. For now, none of this passes the burden of proof that’s required to slow AI enthusiasm.
However, bubble talk can’t be dismissed either and it is not impossible that AI is a bubble. If that bubble bursts, and we see AI enthusiasm taken out of the market, that alone could cause the S&P 500 to drop 10%-20% just on negative earnings revisions (remember the lion’s share of earnings growth in the S&P 500 is from tech). Factor in the negative impulse of cap-ex suspension on other industries (networking, utilities, industrials) and the bottom line is a deflating of the AI bubble alone could cause a correction in stocks.
Scary situation 2: Credit stress hits the economy. Very quietly, the lower end of the consumer spectrum is under stress. We’ve seen hints of this over the past several months but it came up in a bigger way last week, as CarMax (KMX) saw its loan delinquency rate spike and that joins a growing chorus of companies talking about intensifying weakness on the lower end of the consumer spectrum.
The simple logic is this: During the pandemic and following it during high inflation, many consumers were forced to lock in payments for items (cars, appliances, furniture) that were substantially higher than in the past. Back then, rising incomes offset it. But now that income growth has slowed and prices for other items keep rising, these consumers are struggling under these high payments. There are fears this weakness could turn into a minor-ish credit event, especially for lower-end focused finance companies such as Synchrony Financial (SYF), Capital One (COF) and others. If we see a downturn in credit performance, that will weigh on growth and stress the financials. To be clear, I’m not talking about a 2008-style event. I’m talking about stress on the majority of consumer spending that turns out to be a surprise negative.
Scary situation 3: The labor market is a leading indicator and economic growth slows. I don’t think it’s much of a debate anymore that the labor market is weakening. The only question is how bad does it get? Right now, markets assume a little deterioration but generally resilient growth. Practically, think of that like the Unemployment Rate rising to 4.5% or 4.6% and staying there. The problem is that rarely happens. If the state of the labor market turns from the current “not hiring, but not firing either” to “reduce costs, i.e. headcount,” then the labor market will be forecasting an economic slowdown and that is not at all priced into stocks at these levels.
Bottom line, there’s virtually no allowances in the market right now for a recession (for those of you that came into the business after 2010, that’s something from economic history books where growth slows and the market tanks) but they are not extinct! Recessions can and will happen and while no one expects one now, that doesn’t mean it won’t happen.
Now, here’s the horror movie. All three happen at once (which is possible). The AI bubble deflates, the lower end consumer finally buckles and that creates credit issues for financials and consumer companies and the economy broadly slows and contracts under the weight of still-high interest rates, tariff chaos and low sentiment. That is the horror movie environment that would result in a sustainable 30%-ish decline in the S&P 500 that could take years to work off (like in the early 2000s or late 2000s, which was 15 to 25 years ago).
To be clear, I’m not at all saying this is going to happen. But I am saying it’s not a stretch for it to happen, and this is a legitimate negative scenario we all should be aware of, because the outlook for this market isn’t quite as one-sidedly positive as buoyant stock prices would have you believe. If you have been reading my commentaries over the past few weeks, I have continued to remind you that not all is positive for stocks. Markets do like to climb a wall of worry, so this is not unusual. I reveal these potential negatives so that we can keep our eyes open to the signs of danger when they do occur. For now, the markets should end the year higher and with a flourish.
This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources however no warranty can be made as to its accuracy or completeness. The information does not represent, warrant or imply that services, strategies or methods of analysis offered can or will predict future results, identify market tops or bottoms or insulate investors from losses. Past performance is not a guarantee of future results. Investors should always consult their financial advisor before acting on any information contained in this newsletter. The information provided is for illustrative purposes only. The opinions expressed are those of the author(s) and not necessarily those of Geneos Wealth Management, Inc.
Source: Seven's Report 10-6-25