Riding the Wave…and Minding the Undertow

Oil is the channel through which a distant war reaches a domestic valuation multiple: high energy prices keep headline inflation elevated, constraining the Fed from easing into a slowdown. With crude near $100 half a year into the conflict, we do not think the Fed can comfortably call today’s inflation ‘transitory’ — one of the assumptions most likely to reshape our 2027 forecasts.

The uncertain outcome of the war – combined with the contradictory messages emanating from the Fed and Treasury that we discussed last week, as well as a growing US debt buildup – complicate the rate path from here. Low visibility is not the same as bad news — but it does argue for humility in position sizing.

A Boom in Earnings, Not a Bubble in Prices…We’re Watching Tech Cash Flow Closely

Most of the ‘bubble’ indicators we laid out in December also still pass our tests… though some require footnotes. Margin debt as a percentage of market cap remains reasonable against the 10–20% the Boston Fed estimates preceded the 1929 crash. The Nasdaq 100 was fully profitable on our last read, versus more than a quarter of constituents that were not in 1999. Sentiment is optimistic but not at a euphoric extreme, with retail investors and hedge funds increasingly cautious. S&P 500 valuations hover around 20x earnings, a defensible multiple given strong earnings, and not far from their 10-year averages.

Tech cash flow was an important indicator we laid out in our Outlook, representing a proxy of the health of the tech-heavy US economy – and of the quality of S&P 500 earnings. While tech cash flow growth is trending even higher than our ‘Euphoria’ Case, the quality of that cash flow remains solid, in our opinion. Importantly, as we wrote in June, the single most reliable early warning that a technology bubble is deflating is not the slope of the cash flow line — it is the divergence between reported earnings (measured in this analysis by earnings before interest and taxes, or ‘EBIT’) and free cash flow. When profits race well ahead of the cash actually arriving, hype may be outrunning fundamentals. That is exactly what happened into 1999 and 2000: EBIT kept climbing while free cash flow lagged well behind it (see left side of Chart 1 – ‘Tech Mania’ period).

Today the relationship remains supportive of continued gains, though cash flow is no longer outrunning reported profits, as it was earlier this year. Free cash flow across US technology is roughly equal to earnings, with both now over $1 trillion on an annualized basis. What we would expect eventually is for rising tech capital intensity to moderate the growth rate; accelerating hyperscaler capex is already compressing free cash flow at the margin, which is one reason we have trimmed semiconductors and broad tech.

So we are in an unusual position: on the euphoria path for the rate of cash flow growth, and on the boom path for the quality of it. We do not expect that growth to stop any time soon — the capital committed to AI compute power has a multi-year tail, and earnings revisions across hyperscalers and semiconductors have not wavered. The number that matters is the reported earnings to-free-cash-flow spread, and it is not flashing. Until it inverts, we are staying at the party, though we have cut our equity overweight, moving portfolios closer to their long-term benchmarks after a strong run. In keeping with this positive but mixed message, we have resized rather than exited technology; trimming semiconductors and broad tech beta while adding to software, where the selloff hit multiples without touching earnings or guidance.

We have also generally closed our underweight to interest rate sensitivity by adding long Treasury and long investment-grade exposure. A 4.95% 10-year risk-free yield is now a genuine alternative to stocks at current valuations – as Chart 2 below illustrates. While earnings and Treasury yields should not be compared ‘apples-to-apples’ – stocks theoretically are inflation hedges to a certain extent, while Treasury yields are vulnerable to it – looking at historical patterns below suggests that the meaningful undervaluation of stocks relative to bonds that we witnessed in the ‘financial repression era’ from 2008-2021 (notice the gap between the orange and blue lines on Chart 2 below) is now over with.

Still Riding the Wave… but Minding the Undertow as We Surf Towards 2027

Nine months in, our ‘wave’ metaphor still holds; what we would add is a growing awareness of the undertow — a current running beneath a calm surface, set in motion by forces well offshore. Swimmers get into trouble not because the water is rough, but because they are watching the wrong thing.

So, the question for us to tackle in our 2027 Outlook is not whether the boom is real — free cash flow of more than a trillion dollars annually has answered that. Rather, we need to assess the right valuation to assign to those booming earnings, in an environment of rising interest rates. So far, we think valuations are reasonable and thus remain positive on stocks, but we remain vigilant towards our ‘bubble’ indicators. Strong earnings and an economy that avoids stagflation should let stocks persevere through rate uncertainty; we would still view a meaningful pullback in a healthy expansion as opportunities, not exits.

Authored by Adam Grossman, Chris Konstantinos, Kevin Nicholson, Rod Smyth, Dan Zolet

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Artificial intelligence, or AI, refers to the simulation of human intelligence by software-coded heuristics. Nowadays this code is prevalent in everything from cloudbased, enterprise applications to consumer apps and even embedded firmware.

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