Why the Bullish Argument Got Slightly Weaker

Why the Bullish Argument Got Slightly Weaker

Stocks declined modestly last week and rightly so, as two of the biggest supports for the YTD rally had to digest some slightly negative news and given lofty expectations and valuations, it weighed modestly on markets.

Starting with the Fed, rate-cut expectations have been key to this rally since early summer and that peaked two weeks ago as the Fed met expectations, cut rates and signaled two more cuts this year. But the Fed is divided on those two remaining cuts, so last week’s better-than-expected data (especially jobless claims and Q2 GDP) slightly reduced expectations for two more cuts (Fed Watch now has two cuts at a 65% probability, down from after the Fed meeting).

The problem for markets isn’t that the Fed got less dovish (none of the data last week will decide what happens in a month or in December), but the investor expectations are very elevated and that leaves the market vulnerable to small disappointments like what we saw last week with the strong growth data. Since rate-cut expectations helped fuel the rally, the mild reduction in those expectations caused a slight decline.

Turning to AI, we all know that AI enthusiasm has been a major contributor to the rally not just this year, but for the past two-plus years. But as monumental amounts of money are spent to build out AI infrastructure (computing power, electricity, networking, etc.), focus is now turning to the expected return on investment of these hundreds of billions in capital expenditures and investors are starting to get a bit skeptical.

Case in point, last Monday’s NVDA-OpenAI announcement, where NVDA pledged to “invest” up to $100 billion in OpenAI, as long as OpenAI uses that money to buy NVDA products. Announcements like these are becoming more common and it’s raising some questions of why these companies have to keep giving each other money to build out more infrastructure and when all these investments will start to have a positive return (and not need suppliers to fund their biggest customers).

Stepping back, while there were incrementally negative headlines for rate cuts and AI last week, they need to be taken in context and neither were that negative and last week’s news should, for now, be filed in the “not every week can be positive” folder. Point being, the Fed is still cutting rates and AI enthusiasm is still very strong and those are two bullish forces on markets.

However, the mild disappointment last week does reveal the very elevated expectations and those elevated expectations leave the market vulnerable to mild disappointments. If the Fed back tracks on further rate cuts (and makes the September cut a “one and done”) or we start to doubt the ultimate ROI on AI cap-ex, those would be two serious negative events (especially if investors begin to doubt the “magic” of AI). And in those instances, stocks would likely fall, hard.

We aren’t there yet and broadly speaking, the supports of this rally (solid economic growth, Fed rate cuts, AI enthusiasm, stable inflation) remain in place, so despite short-term volatility, the outlook remains positive and we continue to favor large cap stocks both value and growth.

Just a reminder that September has historically been the worst month for the markets. So far so good.

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