Going Beyond

Respect and Kindness

Politically motivated tragic events like Charlie Kirk’s death have unfortunately been part of my reality since I was four, when I wondered why anyone would want to kill that President in Dallas. When these events occur, there is a feeling of hopelessness that can turn to frustration and potentially anger. In searching for a safety valve, we can take a page from Jeff Bezos’ playbook and act on something we can control. So, what do we do? These events are a mirror that we have lost touch entirely with two important words in our culture: respect and kindness. I hope that people can begin to reintroduce those two words into their everyday routine. Trends start in the smallest periods, so we can all begin today and not forget about them tomorrow—respect and kindness.

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The Bullish Thesis?

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Soundbite: The S&P 500 Index is sitting at major 6600 resistance. There are strategists offering a very bullish scenario that we could be in an early-cycle upswing, favoring small caps and cyclicals. They look at long-term growth rates for the mega-cap tech stocks, which puts their stretched price-earnings ratios in a more acceptable context. To their point, we have an analog pattern to the lead-up into the 2000 bubble that suggests the rally could last another year. We are not buying into this thesis, but given the unrelenting upward stock price movement, we examine the uber-bullish view. We conclude that this expectation has largely played out, rather than about to unfold. If the yield curve steepens and small caps outperform, then we will change our minds.

The keep-it-simple bullish view is that stocks rise when they continue to exhibit positive earnings momentum as the Fed lowers rates. The rosy scenario we outlined last week in “What’s So Magical About 2026?” is the working thesis for the bulls: cash flow supportive deregulation and tax cuts, plus a weak dollar, and pent-up consumer demand will coalesce and broaden out the rally.

There has already been a strong recovery in earnings revisions, and yes, that typically signals a move out of a recession. We are aware the bullish thesis has been working, but we cannot detach ourselves from the overvalued and lopsided nature of the equity markets. With a net 20% of companies enjoying higher revised analyst earnings forecasts in the S&P 500, we believe the optimism is coming to an end. To our point, the rate of change in earnings revisions is starting to roll over. The fact that Pave’s growth and momentum factors are the high-scoring foundations to this rally means stock direction is fragile and vulnerable to an economy that fails to deliver.

We would counter the bulls with these two arguments:

· The yield curve is starting to flatten as both the 2-year and the 10-year Treasury note are rallying. This “bull flattener” normally occurs at the end of a cycle, and is a sign of an economic slowdown, not the beginning of a recovery. If that continues, we will take the bond market’s message very seriously. The stock market would quickly follow, resulting in lower, not higher, stock prices. Secondly,

· Given the persistence in Core Services inflation and the small creep higher in Core Goods inflation, the only way the Fed will continue easing is if employment demand contracts even faster than the continuing drop in supply. This hoped-for easing will not fuel an expansion, but will occur to avoid a recession.

A resumption in the steepening trend in the yield curve is the first thing we need to hop on the “early cycle thesis” bandwagon.

Second, we want small caps to outperform. Capital flows toward small caps when the Fed cuts rates because the relative interest rate expense of small caps is more than double that of larger companies. But these stocks only outperform once investors anticipate the economic recovery that the bullish strategists are already expecting. Despite some green shoots in small cap earnings trends, there is insufficient evidence for outperformance. Until that point arrives, we will be looking for any defensive signals from our models below 6600 in the S&P 500 to cut exposure.

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AI Took the Summer Off, But No Winter in Sight

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Soundbite: The Census Bureau asks over one million firms regularly about their usage of AI tools, and there has been a 2% drop to a 12% adoption rate since the middle of June for firms with more than 250 employees. This is the largest drop on record and has some analysts prematurely calling for a 1980s-style AI winter. The drop in interest could stem from the lack of immediate monetization, the higher cost associated with more complex projects, or simply poorly designed projects. We believe that as firms push out on the learning curve, an increased number of applications requiring critical reasoning may have caused this decline in adoption. Bearishly, the reason could be that inherent limitations in LLMs are surfacing. We view this pullback as part of a natural rethink about how to properly deploy AI after the initial rush. A sustained decline may reveal some deficiencies in relying solely on LLMs that will dictate a transition to other available technologies. That could test investors’ patience, but is by no means a death knell for AI.

Similar to the Internet in 2000, we are optimistic about the rollout of this new technology. That does not make us any less concerned about the possibility that we are traveling along the same path now that back then drove investment to such excesses that depreciation costs were impossible to recoup. Those capex extremes ended the tech bubble and aggravated its decline. We find the echoes of this optimism in the infinite data center build and the unlimited demand for GPUs. That is troubling, because the broad stock indices have grown dependent on that theme.

However, we do not think Goldman’s forecast that peak capex is approaching and UBS’s comment that peak “overall AI adoption is still a long way off” are mutually exclusive.

We think firms will work around the problem that applying AI tools to more complex tasks generates higher tokenization costs. Perhaps as companies improve their project focus, it will result in higher efficiency, and that will lead to even higher adoption rates.

A more serious scenario would be if Apple Labs’ 2024 finding is metastasizing within these large firms: as LLMs are pushed to reason, the sequence of decision steps exhibits “a complete accuracy collapse beyond certain complexities...their reasoning effort increases with problem complexity up to a point, then declines, despite having an adequate token budget.” While software innovations have occurred since then, what if these criticisms are still valid? In that case, there may need to be a switch to alternative approaches, such as neuro-symbolic AI that create a logical structure around the fuzziness of the LLM approach. However, re-tooling can take time, and investors may not be patient.

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Argentinian Cutbacks Bite Back

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Soundbite: Argentina held a provincial election in Buenos Aires last week, and President Javier Milei’s party experienced a 13% loss. Despite it being a Peronist (opposition) stronghold, the fact that it represents 40% of the electorate created deep investor concerns ahead of October’s national midterm elections. Milei needs to increase his Libertarian Party’s 10% representation in the Senate at the October 26 election, where almost 50% of the seats will be contested. The markets reacted badly, with the Peso falling 7% this week and stocks underperforming the S&P by 5%. Investors are afraid the loss suggests a voter revolt against the onerous cutbacks Milei has put in place. If he fails to gain enough votes at the midterm election to continue his policies, it could cause increased capital flight. This is a global hotspot for the next month and deserves attention.

Investors bought into the economic miracle of Argentina, where Milei’s austerity programs cut annual inflation from over 200% when he became president to 33%, with the latest report showing just 1.9% m/m inflation in August. His programs helped stocks rise an astonishing 150% in the 18 months since his election in dollar terms. The gloss has turned dull recently; since it peaked in May, the ARGT MSCI Argentina ETF has fallen 35%. In contrast, the S&P rose almost 10% over the same four-month period.

The problems have been compounding. Milei came to power campaigning against corruption, but his sister, deeply intertwined with Javier’s presidency, is in the middle of a bribery scandal. We view her more as a Nancy Regan than an Eva Perόn, and the allegations have tarnished Milei’s reputation in their wake.

Bears are recalling that it was the Peronists who defaulted on Argentina’s bonds, so the prospect of the party regaining power is problematic, to say the least. Milei is submitting the 2026 federal budget next week, and investors are on edge.

Milei lost Buenos Aires in 2023, but won the rest of the country, so there is a strong possibility that last week’s loss will be reversed in the national midterms on October 26. If that happens, then his cost-cutting programs will be passed, and this dip will be seen as a major buying opportunity. Over the next month, equity direction will be determined by the Peso, which has fallen toward its lower trading band. Further weakness could cause the government to react by raising rates even higher, putting more pressure on the economy and stocks.

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What to Look for This Week

(All times E.S.T.)

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1. Wednesday, September 17 at 2:00 p.m. The September FOMC rate decision and the Summary of Economic Projections are released, with investors watching the yearend and 2026 Fed Funds forecast. After the likely 25-basis point rate cut on Wednesday, the Fed has not signaled it will change the Committee forecast for one more rate cut for the remaining October and December meetings, and another one cut in 2026. However, markets are expecting two cuts to follow in October and December, and not one but three cuts in 2026. Investors hope Powell lays out such a path, but we believe they may be disappointed. The year-end and 2026 Funds forecast could move the market before Powell’s 2:30 p.m. press conference. Also, look out for Miran to dissent, adding to worries over Fed independence.

2. Philadelphia Fed Thursday, September 18 at 8:30 a.m. Philadelphia Fed Business Conditions for August. Watching the Capex, New Orders and Prices Paid subindices. Capex is nearing the highs over the last 10 years, matching January 2025 and January 2021 and October 2017. New Orders just fell back into a contraction for the second time this year. Prices Paid moved above 65 in August for the first time in three years.

3. Wednesday, September 17, at 8:30 a.m. August Building Permits. Permits have fallen steadily since Q4 2024, and July hit a 5-year low. Despite the drop in Permits, which is the clearest picture of housing market health, homebuilding stocks have outperformed the S&P 500 for three consecutive months.

FOMC Voters Speaking: FOMC’s External Communications Blackout period lasts until the statement is released on Wednesday afternoon September 17, and surprisingly, no other speakers are scheduled Thursday or Friday, just Wednesday’s press conference. The Bank of Canada may surprise and announce a 25-basis point cut from their 2.75% official rate at 9:45 a.m. followed by their 10:30 a.m. press conference the morning of the Fed decision. The Bank of Japan Interest Rate Decision is out at 11 p.m. Thursday September 18 a few hours after their Inflation Rate for August is released. Japanese inflation peaked at 4% in January and has fallen steadily to July’s 3.1%. No rate change expected from 0.5%. The Bank of England should leave rates unchanged at 4.0% when they meet earlier Thursday at 7:00 a.m.

Earnings: Only 41 companies scheduled to report through Thursday. Thursday has two companies of note reporting after market close: FedEx and Lennar. These two conference calls could lend insight into consumer spending and housing market outlooks.

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