Can the old bull learn new tricks to keep his owner happy? Already a third of the way into its fourth year, the 2026 bull market is drawing out a new constituency, one that is markedly different from the one that started and sustained its rise. Each of the core drivers of the S&P 500 index’s nearly doubling from its October 2023 lows has been questioned or replaced by other, more hopeful sources. Cash generation from growth stocks recedes in favor of the promise of productivity. Disinflation allows for lower policy rates, leading to fewer interest rate cuts and a “wild” nominal GDP surge. And what used to be a supposedly “hated” market with a high wall of uncertainty has turned into an attack tool for retail investors to buy every push and exaggerate every momentum move. From the beginning, this has been an upward trend fueled by AI. However, over the past three months, the AI sector has been broadly stagnant. Both the Magnificent 7 stocks and the Global AIQ 6M Mountain Global (Netflix hired bankers in its bid in late October, stealing confidence from the “tech mixer” crowd. Just look at the one-year chart of Spotify vs. Netflix. Both companies have fallen significantly in recent months, even though only one is trying to shore up acquisitions of legacy media businesses.) NFLX SPOT 1Y Mountain Netflix vs. Spotify, one year Or perhaps the drop was when the gears of the “cyclical up” trade clicked and the Federal Reserve resumed rate cuts. A tax stimulus package is on the horizon in September. Will small-cap stocks and cyclical stocks take the lead? Whatever the catalyst, the vaunted “expansion” trade worked extremely well within its inherent limitations. Cyclical stocks, small-cap stocks, and banks have all outperformed since the peak of AI dominance. My consistent view here is that the broader market is not necessarily a more stable or profitable market overall. This is perfect for active stock pickers and may send a reassuring macro message that sectors most sensitive to economic rhythms are leading the way. But despite repeated attempts, the S&P 500 has failed to surpass its late October high, and strategists’ collective index target of 7,600 will be harder to reach if Mag7 stocks continue to be treated as a “funding source” for acquisitions of Caterpillar and Citigroup. What’s more, big bank stocks have fallen since the group began reporting generally strong results the week before last. The crash in the small-cap Russell 2000, which outperformed every trading day this year through Friday, says less about the real economy and more about late-starting, leveraged and hoarding of low-quality stocks. For now, small-cap stocks’ breakout to new highs should be respected after numerous head fakes since 2021. It would probably be healthier if the S&P Small Cap 600, which has higher quality, more profitable small-cap companies, started closing the gap with the Russell 2000. I always point out that the upper reaches of the Russell 2000 are full of speculative “story stocks” such as Bloom Energy and Credo. Technology, Oklo, Joby Aviation, IonQ. Interestingly, the salt of the earth has very little impact on the core of the American economy. Back to the old rules of bull market turmoil: The sustained leadership and premium valuations of a handful of the largest technology platform companies have long been justified primarily by citing their abundant and effortless production of free cash flow. Now, as Alphabet, Microsoft, and Metaplatforms accelerate data center capital spending, free cash flow growth has slowed, and the Nasdaq 100’s expected FCF for the year ahead has increased from about 24 in late 2023 to 32. This valuation metric is now higher than it was in late 2021, before the start of the tech-driven bear market, even on the Nasdaq. The forward P/E ratio in the $100 range has fallen from almost 29 in October to 26 now. It is true that hyperscalers can afford this level of investment and are clearly happy with the increased user demand and revenue associated with AI capabilities. But the idea that these companies can do it all while accumulating shareholder surplus and buying back significant amounts of their own stock is less relevant today. Before dismissing the idea of Mag7 exceptionalism, it’s important to note that there have been interludes like this before, during multi-month periods when the Nasdaq 100 fell and the market’s healthy rotational forces allowed the rest of the market to bear the load for a while. And we enter a week in which most of the big tech companies report lower-than-usual earnings relative to expected benchmarks. A pivot to long-term growth stocks makes some sense here, but perhaps makes more sense as the consensus seems a bit off. Is it hot? Kudos to the market for enduring this situation, as the Fed’s expected rate path is no longer dovish. Market prices now expect fewer than two quarterly point rate cuts across cards in 2026, down from three in November. The expected reduction in Fed easing is now easier to digest thanks to previous growth dynamics. The Citi U.S. Economic Surprise Index has surged in recent weeks and is now near a two-year high. This has led to speculation that the Fed will soon approach the final rate of the cycle. While not necessarily harmful, it is another sign that this bull market has reached a certain level of maturity. As the first nine months of last year showed, the Fed’s comfort in keeping policy on hold is one of the more bullish mood factors. Run It Hot Theme Questions: Are the benefits of cyclical stock outperformance already being paid forward? Is the recent sharp decline in consumer savings rates a sign that a big tax refund opportunity has been brought forward? Will long-term Treasury yields remain in a good range as this unfolds? Of course, there are other ways to read these dynamics. Morgan Stanley strategist Mike Wilson argues that after a series of “soft recessions” ended last year, much of the economy and stock market is gearing up for an early cycle that will deliver superior earnings growth in 2026 that more than justifies current valuations. This outcome is not yet determined, but it is definitely included. Finally, a word about the change in the behavior of investors who, after three years of large profits and a series of “V” bottoms have caused a panic correction, are willing to buy modest pullbacks and bet on fast price movements. Overall sentiment is decidedly optimistic in most respects, although not extremely volatile. Tony Pasquariello, head of hedge fund coverage at Goldman Sachs, said in recent weeks that his client’s positioning was a “plus 8” on a scale of minus 10 to plus 10. Retail trader engagement is hitting new highs, based on indicators of options trading volume and retail investor inflows into JPMorgan’s individual stocks. Last week, “Sell America” redux fears were quickly bought after the S&P 500 fell 2% in Greenland on Tuesday, with some equating it in some way to a rebound from last April’s 20% mini-crash lows. With the Greenland dispute being laughed at and the Justice Department’s attack on Fed Chairman Jerome Powell largely forgotten two weeks later, is it a good thing that investors are starting to believe that markets are used to some kind of shock? Volatility across macro markets is difficult to ignore. Concerns about a weak dollar and ominous rumors about hoarding supplies have sent gold and silver galactic up, the Japanese yen has soared on Friday on talk of possible central bank intervention, a severe physical shortage of low-value chips has sent memory product makers around the world vertical, and the Nasdaq Biotechnology Index has soared right in lockstep with the Russell Micro-Cap Index. All of this has kept stock indexes near all-time highs, while corporate bond spreads have been subdued and bond market volatility remains subdued. It’s certainly a dynamic and somewhat contradictory market moment, but so far the uptrend remains intact and optimists are encouraged.
