Q3 2026 Market Commentary

After falling more than 10% earlier this year, the major equity markets including the S&P 500 (SPY) and Dow Jones Industrials (DIA), are now up decently on the year while the AGG Intermediate Bond Index (AGG) is still down on the year, due to a rise in interest rates. We welcome the equity turnaround. In this commentary, we will give an overview of why the market has rebounded and why current valuations give us concern for the future.

Coming into the New Year, we wrote how valuations were high, and the financial markets did sell off. However, the U.S. economy is still on solid ground, with low unemployment, growing corporate earnings (see chart below), and expanding U.S. profit margins (see chart below). With expanding profit margins and double-digit corporate earnings growth, recession risk remains unlikely. Moreover, even with elevated fuel and inflation being driven by the Iran war, the U.S. consumer is still in a position to spend with debt servicing payments a percent of disposable income still at relatively low levels.

Rail traffic also confirms a resilient American consumer with freight traffic within the USA up +3.4% year to date as of July 3rd 1. While consumers are in good shape by historical standards, it is a skewed number. We would note that the upper two thirds of consumers, who own their own homes, and have stocks, have enjoyed market appreciation, and are doing much better than the lower one third who do not own their own homes or own stocks and yet are facing higher prices without the asset growth. The upper two thirds of consumers account for almost 85% of consumption and tend to overcompensate the consumer consumption numbers.

While a prolonged shut down of the Strait of Hormuz has affected fuel prices and inflation, over time the U.S. economy has become much more resilient against energy shocks. During the 1980s, the Bureau of Economic research reports that the average U.S. consumer wasspending almost 10% of their disposable income on fuel and energy (including home utilities), today this number has dropped to 5.7%. During this time, the U.S. has become the world’s largest producer of oil and natural gas, and new technologies increased vehicle fuel efficiency. In 1980, the Environmental Protection Agency (EPA) estimated that the average vehicle got 19.2 MPG (Miles Per Gallon), vs 27.2 mpg for the average vehicle in 2026, even though SUV’s and light trucks now make up 66% of all new vehicle production. Utility use has been even more efficient, due to advances in insulation, window technology, high efficiency HVAC (heating ventilation and air conditioning), LED lights, and energy star appliances. The U.S. Energy Information Administration reports that the average energy intensity of an American home (energy used per square foot) has plummeted by 40% since 1980.

Also encouraging is that outside of energy cost rising, inflation has not been spreading to other areas of the economy, at least not yet. According to First Trust Chief Economist Brian Wesbury, energy prices surged 23.5% over the past year in the May report and contributed 1.76 percentage points to the 4.2% all-items inflation reading — 42% of the entire annual increase coming from a single geopolitical supply disruption3. Gasoline alone is up 40.5% over the year. Strip energy out and the all-items index of inflation rises just 2.4%, which is almost in line with the Federal Reserve’s target range for inflation. The goods picture is particularly striking. Core goods prices fell 0.1 percent in May on a seasonally adjusted basis. Durable goods are essentially flat year-over-year. New vehicles are up just 0.2% over the year. Hopefully this holds. Currently the market is pricing in that the energy price increases are temporary disruptions. The June Inflation Report that was released on July 14th by the U.S. Bureau of Labor Statistics is more hopeful. Inflation declined to 3.5% year over from the previous month gain of 4.2%. However, if the Iran War continues to flare up or looks permanent, then energy prices will likely seep into other sectors of the economy, but so far that has not happened.

While energy conservation over the past several decades has put the country in a better place to deal with energy shocks, we believe the current solid economic backdrop is being driven primarily by the expanding use of AI and corporate automation as well as the massive amount of capital expenditure needed to build the data centers for AI to operate. Goldman Sachs estimates that just the major hyperscalers (Amazon, Alphabet- parent company to Google, Meta, and Microsoft) are investing $600 to $700 billion on AI data centers infrastructure in 2026, up + 50% from 2025 levels, with long term projections of $7.6 trillion across compute, power, and facilities by 2031. According to the National Bureau of Economic Research, AI data center build out is now approaching 4% U.S. Gross Domestic Product (GDP). To put this into perspective, the rail road build out at its peak in the late 1800’s reached roughly 5.5% of U.S. GDP. This growing demand for compute, memory chips, power, and infrastructure has driven profit margins on the companies that provide these services to all-time highs and has greatly helped the financial markets to recover quickly from the pull back earlier this year.

On the contrary, the large hyperscale companies which stand to make the most money long-term by generating reoccurring revenue from their AI investments once the AI build out is complete have seen their stock prices struggle this year. This is because they have had to cut back on their growth of share buybacks and dividends and have instead increased their capital expenditure budgets. This has put pressure on those stocks. In fact, as of early July, William O’Neil + Co reports that Microsoft (MSFT) has had its worst start of the year since 2002, and is 31% off its high. Meta (META) also known as Facebook is -24.45% off its high, Amazon (AMZN) is -12.5% off its high, while Alphabet, parent of Google is -11% off its high. Oracle (ORCL), one of the leading infrastructure providers to Open AI is off almost -57% off its high.

Going forward, we expect the economy to remain solid given the estimated corporate capital expenditures. The problem we see is that JP Morgan reports the current trailing twelvemonth (TTM) P/E ratio for the S&P 500 hovering around 26.70, while forward estimates range closer to 20.4. These figures generally indicate an overvalued market compared to the long-term historical average of forward P/E approximately of 17.2. More concerning is current Shiller P/E ratio, also called CAPE for cyclically adjusted price earnings ratio, which measures the price divided by the 10-year average of inflation adjusted earnings to smooth the business cycle. The current Shiller P/E ratio stands at 40.7x. Advisor Perspectives reports that this is in the 98th percentile of all historical data. That means that there is very little room for any disappointment in the current market valuations.

In addition, we are seeing an increasingly large pipeline of new IPO (initial public offerings) getting ready to hit the market. We like to buy companies that are buying back their own stock. Over time this increases earnings per share as new earnings get divided over fewer shares, causing equity prices to rise. When new companies hit the market the money to buy these shares usually comes from investors existing equity portfolios, which can cause selling pressure on all stocks. Furthermore, when the companies coming public are trading at high valuations, it can make the situation worse. For example, SpaceX (SPCX) which is a great company and will most likely go on to do great things in the future, trades at a valuation of $1.7 trillion but, only has revenue of $18 billion, and they lost $4 billion last year. In comparison, the entire country of the Netherlands has a Gross Domestic Product (GDP) of $1.33 trillion and is expected to hit $1.4 trillion GDP by the end of 2026. If the country of the Netherlands were for sale (which it is not), and you could buy that country at its GDP value, you could buy the country of the Netherlands for $300 billion less than it would cost to buy SpaceX. We saw these types of high valuations during the end of the .com era between the late 1990’s and early 2000’s when private companies rushed to take advantage of the elevated valuations during that time frame. During that time, December of 1999- March 2000, the Shiller P/E ratio, hit an all-time high of 44.2x. Below is a chart of the new equity issuance for 2026.

Typically, it is more positive for stocks when companies buy back their shares because it reduces supply, and causes prices to rise. When companies issue shares or have new public offerings, supply is added to the market, which causes prices to fall. As you can see from the chart above, stock prices tend to rise in years when corporate buybacks reduce supply, and fall when suppy is added. While Open AI and Anthropic have not come public yet, from the chart below you can see the sheer size of these potential IPO’s relative to what we have seen over the last 20 years.

In conclusion, we believe the economy remains on solid ground driven primarily by historically high levels of capital expenditures which are being used to build out data centers necessary for the AI boom. What concerns us is that the current valuations in the equity market, which are high by historical standards, already reflect a very postive economic backdrop leaving little cushion for any economic uncertanity. Any economic scare or additional geo-political event could easily cause stocks to fall 5-10% very qucikly. However, we also believe that the AI build out will continue, and that earnings growth of America’s largest companies will continue to do well due to the massive forecast of capital expenditues around AI. As a result, we continue to like large capitalization, brand name 9 companies who provide goods and services that business and consumers need to use on a daily basis, and who are returning cash back to investors from both dividends and share buybacks as the best path to risk adjusted returns.

Thank you for your continued support.

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