A Cautious Tone

Investors are becoming more concerned that the optimism surrounding AI and AI-adjacent companies may be overdone, particularly in the context of historically elevated equity valuations. Worries about stock prices and valuations getting ahead of industry and company fundamentals have put the focus squarely on these stocks, which have been leading the market for several years. With AI such a dominant theme — and a dominant force — in the market, we do see an extreme in terms of concentration within popular benchmarks: This is exacerbated by the high correlations between many of the stocks that operate in the AI ecosystem.

Concentration does heighten risk, but it is worthwhile to step back and assess these companies from a fundamental perspective: Substantial growth in revenues and earnings and strong cash flows tend to characterize today’s tech darlings. While investors seem to be paying dearly for these constructive fundamentals, we can look to prior periods of tech exuberance — the 1999-2000 period, for example — for context. We note that today’s valuation of the MAG7, at 27X the two-year forward P/E, pales in comparison to the 52X seen during the dot-com bubble. Moreover, the underlying trend related to AI appears to be durable, with adoption growing exponentially from a still relatively low level. Furthermore, the strength in AI appears to reflect a structural shift supported by investor optimism rather than a cyclical bubble driven by irrational exuberance. The runway for continued positive results is long, but the index concentration and “high hopes” for these companies injects additional risk into the equity market.

Macro concerns are also grabbing headlines as more signs of economic weakness are revealed by incoming data. In particular, the apparent surge in layoff announcements has raised a red flag against a labor market that had been slowing but relatively stable. Conventional wisdom suggests that, when faced with the prospect of a slowing economy, companies will first cut back on hiring. We certainly have seen this in the monthly non-farm payroll reports, although the last official report was for August. We also saw weakening in the Job Openings and Labor Turnover Survey (JOLTS), though — again — the official data has been delayed due to the government shutdown.

The next phase of the labor market evolution would be actual layoffs and a reduction in the absolute level of employment. Unfortunately, last month, U.S. companies announced the most job cuts for any October going back 20 years, according to outplacement firm Challenger, Gray & Christmas. Companies announced over 150,000 job cuts, with an emphasis on the technology sector. Year-to-date layoffs exceed 1 million — the most since the COVID pandemic. Of course, the ongoing government shutdown continues to impede the availability of timely, official economic data, further reducing visibility.

The nature of the recent rally in risk assets was nearly a perfect setup for a period of weakness in two critical ways: The rally was very narrow in the large cap space and low quality in the small cap space. Both of these elements increase the overall market’s fragility against any change in sentiment or news flow.

Among large caps — as noted in a prior Weekly Five — performance has been driven by the mega-cap technology names, leading the capitalization-weighted S&P to drastically outperform the equal-weighted index. This dynamic is typically referenced as “bad breadth,” with the narrowness of performance creating instability. We have seen that come to fruition recently, with the leaders becoming laggards. This week, the large cap tech / MAG7 names have underperformed the “other 493.” Currently, both the equal- and cap-weighted S&P 500 are in negative territory for November. 

For the small-cap Russell 2000 index, overall performance had picked up significantly over the past few months, led by the lowest quality areas. From April through October, the index has advanced over 40% , with meme stocks and unprofitable tech names leading the way — some with advances in excess of 100%. When uncertainty rises, however, the lowest quality tends to underperform, and that is exactly what played out this week. Healthier markets are built on a foundation of broader participation. 

All that said, the market weakness seen in November is far from a panicked downturn: Market volatility, as captured by the VIX, has increased from just under 17 to 21, but it remains well contained and does not indicate significant market stress at this point. For reference, the VIX surpassed 50 during the Q2 panic over trade policy.

From a fundamental perspective, the market has benefitted from a generally strong earnings season. But with the season nearly over — and with no Fed meeting until December — the market is in a bit of a news air-pocket. The Q3 earnings season has, to date, seen over 80% of reporting companies beat estimates by a wide margin. Moreover, the overall expected growth rate for Q3 earnings that started the quarter at 7% has jumped to 13%, bringing 2025 expected growth in earnings-per-share for the S&P 500 to over 11%. Consensus estimates for 2026 call for a 14% increase. This conforms to our view that the global economy will slow down next year but will still provide a positive macroeconomic tailwind to earnings. At the same time, we maintain confidence that profit margins will remain high against a backdrop of productivity-enhancing AI spending and investment.