If you want something to blame for the market’s recent sideways environment, you can point your finger at the bond market. While The Fed can try to control near term rates, they cannot control long term treasury yields…investors get to decide on those, and right now, investors are demanding a lot more compensation to lend the U.S. government money for 10, 20 or 30 years.
The 10-year Treasury yield reached its highest level since 2002, briefly climbing above 5.3%. That matters for us on the market because bond yields are now pretty attractive…Why take significant risk buying stocks when you can earn more than 5% lending money to the U.S. government? This raises the hurdle rate for equities. A company trading at 30x, 40x or 50x earnings has to offer investors enough future growth to justify owning it when supposedly “risk free” government bonds are paying north of 5%.
Higher long term yields also work their way through the rest of the economy, they hit:
- Mortgages
- Corporate borrowing costs
- Refinancing debt costs
Moreover, future corporate earnings become worth less when investors discount those earnings back to today at a higher interest rate. This is why we see so much pressure on growth stocks (like tech stocks) during times when rates are high.
The Good News (Mixed)
As of this morning, the market is pricing roughly a 38% probability of another hike in October, down from around 51% yesterday and 71% a week ago. This is the good news…the mixed part is that long term Treasury yields are still high. This is a curveball because in a “normal” market, soft inflation + lower expectations for Fed hikes should help bring yields down…that didn’t happen. Investors need more evidence that things are normalizing…right now they still want higher compensation to lend the government money…one good inflation report isn’t going to cut it.
Oil is still around $100 per barrel, enormous government borrowing needs, growing Treasury supply and concerns surrounding government deficits. Similar pressure is appearing across global bond markets as investors demand greater compensation for lending money long term…we can put this on geopolitical instability.
Where AI, or Super Intelligence, fits in all this
The AI boom propelled the market higher over the past two years, but it has seemingly come to a halt. The spending that hyperscalers committed over the coming years (on chips, data centers, networking equipment, power…etc) fueled growth, eclipsing the weakness elsewhere in the economy. But that very demand and spending is now starting to weigh on market in two ways:
- Memory prices are now inflationary - AI data centers require enormous amounts of memory. More demand + a tight supply chain causes a downstream effect on prices for phones, computers, electronics, storage…etc.
- The borrowing costs of these hyperscalers are growing - for years, companies like Microsoft, Google, Amazon, Meta, and Alphabet were cash printing machines, but they’ve used up all their cash (figuratively, for some) on the AI buildout. There is a path where these companies become like utilities…the data centers will be necessary for companies like OpenAI and Anthropic to run…hyperscalers’ business models will likely shift towards maintaining data centers.
Many of the hyperscalers are even issuing debt to complete the buildout…that’s mixed news because on one side, the AI boom is still very much happening, but on the other, everyone’s competing for money…that naturally makes the cost of capital more expensive.
Key Takeaways & Action Plan
- Bond yields are still the biggest hurdle. If yields cool, the market is well set for a rally.
- Inflation is showing signs of cooling.
- The memory crunch is expected to last beyond 2027
- Rate hike odds fell significantly from last week
- Oil flowing out of the Middle East is restored to roughly 80% of pre-conflict levels
Despite all of these headwinds, we haven't really seen what I would consider panic selling. The Dow and Russell 2000 have taken considerably more damage, while the S&P 500 and Nasdaq have remained relatively resilient because mega-cap technology and AI stocks continue to attract capital. Once that breadth closes and small caps, financials, and industrials start participating again, it could act as another bullish catalyst for the market.
We’re going into Q4 with confidence that earnings can eclipse the headwinds the market is facing. The AI boom is unprecedented…truly remarkable. Companies are posting massive year over year revenue increases with 50%+ profit margins. The market recognizes this, and this is why we’re not seeing any “panic” selling. We’ll continue to add into fundamentally strong companies that are highly relevant in their industries / sectors.