Q1 2026 Market Commentary

1st Qtr 2026 SCM Market Commentary.pdf

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As we enter the new year, clients have asked if this market can continue to go up after three years of growth, and are we due for a recession? In this commentary we will discuss that we are due for a sell-off in the market because valuations are high, but we think it will be a buying opportunity as we do not see a recession in 2026, and we think the Artificial Intelligence buildout that has been leading the market will continue.

The S&P 500 heads into this new year at expensive valuations after three good years in a row. Historically, the S&P 500 trades between 13.8 and 20.4 times earnings going back 30 years according to J.P. Morgan Research. Currently, the S&P 500 is trading at 22 times earnings, which is almost 10% above the upper end of the trading range, and only happens 16% of the time. Market Capitalization/Sales on the S&P 500 over the last 25 years has averaged 1.6 and the market currently trades at an expensive 3.28 according to Dow Jones and Y Charts. Charles Schwab also reports that Price/Book Value, Market Capitalization/GDP, S&P 500 Dividend Yield/10 Yr Bond Yield all trade at very expensive levels. On the economic front, the National Bureau of Economic Research states that the average economic expansion since 1949 has lasted 67 months, and we are currently 65 months into the current expansion, which suggest we may be nearing a recession. Most concerning is that Barchart reports going back to 1926, mid-term election years have had average sell-offs of 18.2% as markets brace for uncertainty before the mid-term elections. Traditionally, the stock market is up 74% of the time (three years out of four on average), however, mid-term election years are up only 53% on average. (Barrons Magazine 1-3-26). So, there are many reasons to expect a selloff in the markets in 2026, and we do expect at least one 10% sell-off to bring markets back to historical valuation levels. However, we believe a sell-off in the markets this year would be a buying opportunity, and that the markets will end the year higher.

Traditionally, larger market sell-offs have been caused by economic recessions, and we do not believe that we are headed for a recession. In fact, the Commerce Department’s Bureau of Economic Analysis reported the U.S. economy grew a revised 4.3% in the third quarter, picking up from the 3.3% economic growth from the second quarter, and contraction of -0.5 in the first quarter. The recent quarters growth are very impressive numbers for an economy our size. Moreover, even though this expansion has been going on for over 5 years, which is a long time, the longest economic expansion since 1949 lasted for 10.6 years, so there is still potentially plenty of upside left. Rail traffic and truck traffic as reported by the National Association of Railroads and Truckers also both show freight expansion for the year 2025. We have never had a recession with expanding freight and rail traffic. The Index of Leading Economic Indicators put out by the Conference Board also suggest growth, albeit modest growth, for 2026.

The bond market also points to growth for the year 2026. Every recession in the last 75 years has shown an inverted yield curve where short term interest rates were trading higher than long term interest rates. The current interest rate is showing a positive (normal) sloped curve which suggests bond investors are not expecting a recession. The reason why an inverted yield curve would suggest an upcoming recession is that if investors expect lower interest rates in the future (3-5 years out), then they are pricing in a recession and the Federal Reserve Bank will need to cut interest rates 3-5 years out to deal with the recession. Just as importantly, the interest rate spread between investment grade bonds and U.S. Treasury bonds is near five-year lows as shown by the Federal Reserve Economic Research (FRED) chart on the top of the next page. This spread is important because it measures how much risk is priced between riskless U.S. Treasury investments, and more risky corporate bonds. When the spread is low, investors are forecasting smooth sailing, economic expansion, and little risk. When the spread is high, investors are concerned about recessions and possible bond defaults. Currently, the spread is low.

In addition, the U.S. consumer is still spending, holiday sales for 2025 showed solid growth year over year of 4%, and topped $1 trillion for the first time according to National Retail Federation. We expect the spending of U.S. consumers, who account for 70% of American economic activity to continue. Currently the United States accounts for 36% of global consumption and 26.84% of global economic activity according to the World Bank. However, the top 10% of high-income American households account for almost 50% of U.S. consumption (and 18% of Global consumption) (see chart below). These top 10% of U.S. households are doing well and have seen their net worth expand with higher equity markets and will continue to spend. According to USAFacts, 65.6% of Americans own their own homes, their mortgages are stable, their home values are up, their investment accounts have done well, and they are spending. So, we are in a situation where top consumers are doing well, but the bottom third of consumers who do not own their own home, and who do not own stocks are not doing well as their costs have gone up, but they have no assets that have appreciated to offset those higher expenses. This is also why consumer confidence numbers are still stuck at low numbers, and have been used by some commentators to suggest the American consumer is weakening.

Besides recessions, the leading reason for stock market sell-offs is a decline in earnings on the S&P 500. The good news here is that FactSet Research, which aggregates Wall Street earnings estimates, projects that the earnings on the S&P 500 will grow 12.5% this year. Furthermore, the profitability of the S&P 500 has just hit a new high as Artificial Intelligence (AI) improves efficiency. Earnings on the S&P 500 are also increasing because the composition of the constituents making up the 500 largest companies in the country continues to morph to more profitable technology companies, which now make up almost 50% of the index, from less profitable, more capital intensive industries like steel and autos which were more common in the index 30 years ago.

Many of the concerns of analysts and investors are that with valuations high, and tech stocks rallying over the last three years, we are nearing another tech bubble. In particular, the worry is that the market is acting like the tech bubble of the late 1990’s that formed during the internet build out, and like the tech bubble, this market rally will end with a big market crash. While, we agree that valuations are high, and that we are due for a market correction to bring valuations down to more normal levels, we do not think that another tech bubble popping is imminent.

First, the tech bubble of the 1990’s lasted six years and we are only three years into this current expansion. Second, the adoption rate of Artificial Intelligence (AI) is still low. Goldman Sachs came out with a report in November that reported only 11% of the S&P 500 is actually using AI. So, we are still early in the buildout, and early in the adoption rate of AI. What is interesting is that Bloomberg and Wells Fargo came out with a report in November that showed the market appreciation of the technology bubble compared to the current market, and the last three years of the AI expansion stock market appreciation have been almost exactly similar (See Charts below).

However, the tech bubble lasted six years, and it is the last three years of the tech bubble where the majority of the gains came from, and that has not happened yet. In fact, the current Price/Earnings (P/E) ratio of the of the technology sector is 37, which is far below the 100 times P/E ratio tech stocks traded at the top of the tech bubble in the year 2000. Likewise, the most expensive tech stocks traded at 216 times earnings (P/E) in 2000 while today the most expensive stocks trade at 56 times earnings (P/E/) (see chart below).

So, the tech sector would need to appreciate another 270% to reach the valuation at the top of the tech bubble.

Next, the current AI buildout has not reached the size or frenzy of other large new technology buildouts. For example, according to the research firm ZeroHedge during the railroad buildout of the 1880’s, railroad investment totaled 3% of U.S. Gross Domestic Product (GDP), during the auto buildout of the 1920’s the investment in new automobiles also reached 3% of GDP, during the tech bubble of 1994 to the year 2000, investment reached close to 3% of GDP, while the current AI buildout is still in the 1.5%-2% of GDP investment.

In conclusion, even though technology stocks have had a large upside move over the last three years, and they are due for a pullback this year, the AI buildout still likely has more upside because it is still only three years into this buildout, the percentage of GDP spent on the buildout is less than previous buildouts (like the railroad, autos, or internet build outs), the adoption rate of AI among large companies is still low, and valuations of technology still have more upside before they reach valuations of previous technology buildout cycles.

In regards to the economy, we expect to continue to see growth. Rail and truck traffic indicate the economy is expanding, the yield curve on the bond market and the yield spread between safe assets and riskier assets also point to growth in the economy this year. Earnings growth on the S&P 500 are expected to grow over 10% this year, and the top consumers, who account for the majority of consumption are flush with cash on home and stock market appreciation, which suggest they will continue to spend.

That being said, we do expect more volatility. Mid-term election years typically have sell-offs, and we enter this year at already high valuations on the stock market which could intensify selling. We do think that if there is a sell-off it will be a buying opportunity. As a result, we continue to favor large capitalization, brand name equities who are providing goods and services that consumers and businesses need on a daily basis and who are returning cash back to investors as the best risk adjusted returns.

Sincerely,

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