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US MARKET CALL: Investors Curbing Their Enthusiasm As Less FOMO Offsets More FEMO
I. Curbing Our Enthusiasm Last week on Tuesday, we pushed our 8,400 year-end target for the S&P 500 to mid-2027. Our new year-end target is 7,900. We remain confident in the resilience of both the economy and S&P 500 companies’ earnings per share (EPS). On the other hand, we think recent developments may weigh on their stocks’ valuation multiples for the rest of the year. The recent re-escalation of the war in the Middle East increases the chances of higher-for-longer oil prices and stickier inflation. As a result, the FOMC voted unanimously to hike the federal funds rate (FFR) last week, and the Committee seems set to tighten some more in the coming months. Bond yields remain on an uptrend worldwide. A growing backlash against the proliferation of AI is also weighing on valuation multiples. It is becoming a political issue during midterm congressional campaigns, and the election results are likely to exacerbate the partisan divide in the US. Then again, perhaps President Donald Trump will soon find a way to end the war, causing oil prices to drop. Perhaps China will convince Iran's IRGC to stop their Houthi friends in Yemen from disrupting shipping through the Red Sea. Perhaps bond yields will stop rising. Perhaps. In any event, our base-case scenario remains a continuation of our Roaring 2020s scenario, which has been underway for almost seven years. It posits that rapid, noninflationary economic growth will result from tech-led productivity growth. We give it 70% odds of continuing. So far, so good: Three more years to go. Nevertheless, we'll keep updating our worry list of unhappy scenarios, which currently has a subjective probability of 30%. For now, let's review the recent developments in the financial markets. II. Earnings Exuberance S&P 500 companies’ forward EPS rose to a record $404.84 last week (chart). The analysts' consensus 2027 EPS estimate is up to $419.93. We expect it to keep climbing to $425 by year-end, which would put forward EPS at $425 too. Multiplying that forward EPS target by a forward P/E of 18.6 yields our year-end target of 7,900. To get to 8,400 by year-end, the forward P/E would have to rise to 19.8. The current forward P/E is 18.9. The Q3-2026 earnings season starts in early October. Analysts project 23.7% y/y growth for Q3 and 28.2% for Q4 (chart). Both estimates continue to rise. Q2's 50.8% jump included huge mark-to-market capital gains; excluding those gains, EPS growth was about half that. Analysts’ estimates for the second half of the year carry no such distortion. Forward earnings rose to record highs for the S&P 500, S&P 400, and S&P 600 last week (chart). Fabulous earnings momentum (FEMO) isn't just a LargeCap story. III. Valuation Compression The S&P 500’s forward P/E is down to 18.9, with the Magnificent-7’s at 22.7, the S&P 400’s at 15.1, and the S&P 600’s at 14.3 (chart). As earnings have soared this year, forward P/Es have declined. FEMO has been partly offset by less FOMO (fear of missing out). While analysts have been increasingly exuberant about earnings, investors have been curbing their exuberance. Investors want a valuation discount for the known unknowns: How far will the Fed tighten from here? How long will the war last? How high will oil prices and bond yields go? What will the midterm elections deliver? Will the AI labs' push to slow frontier development slow the capital-spending boom driving earnings? By how much? The Fed's Stock Valuation Model (named as such by Dr. Ed in 1997) is working again (chart). The S&P 500 earnings yield and the 10-year Treasury bond yield are moving in tandem. Rising bond yields are depressing the forward P/E, which is the reciprocal of the forward earnings yield. Analysts' consensus long-term annual earnings growth (LTEG) expectation is up to 26.6%, as analysts have kept raising what they think their companies will earn over the next five years. That’s well above the 18.9 to which the S&P 500 forward P/E has fallen (chart). During the 1999 Tech Bubble, both LTEG and the forward P/E moved higher together and then fell together during the Tech Wreck. Their disconnect now shows that investors aren’t completely buying what analysts are selling. IV. Investor Sentiment Mixed The Investors Intelligence Bull/Bear Ratio eased to 2.88 last week, close to its 2.60 average, while the AAII ratio fell to 0.54, well below its 1.18 average (chart). Institutional bullishness has come off its summer extreme, and retail remains washed out, which is constructive on a contrarian read. V. Bond Yields On 5% Fence Following Wednesday's FOMC decision, the 2-year Treasury yield is at 4.67% and 12-month FFR futures is at 4.66% (chart). They both imply roughly two and a half more 25bps FFR hikes over the coming year. The 10-year Treasury yield is at 5.00%, the top of the 4.00%-5.00% "old normal" range that we have argued is the right one for this business cycle (chart). A sustained Fed tightening cycle could push yields into abnormal territory. The good news is that breakeven inflation rates dropped sharply after the Fed raised the FFR on Wednesday (chart).
Global Bond Rout Made In Japan?
I. Yen-Carry Trade Unwinding? The “yen‑carry trade” has been a key feature of global financial markets since roughly 2012. It rested on two pillars: ultra-low Japanese interest rates and either a weak or relatively stable yen. Hedge funds could borrow funds cheaply in yen, convert the proceeds to other currencies, and buy government bonds in those currencies. The beauty of this trade is that it increased downward pressure on the yen as long as the Bank of Japan (BOJ) kept its official policy rate near zero (chart). Today, both pillars are cracking. Since early 2024, after years of near-zero and even negative rates, the BOJ has raised its official policy rate to 1.0%, the highest since 1995, with another 25bps hike expected tomorrow morning. Meanwhile, the yen has become more volatile and is expected to strengthen in response to tighter monetary policy. After weakening to around ¥163 per dollar, near a four-decade low, it has rallied since late July following joint Japan-US intervention in the forex market. Higher Japanese interest rates and likely further yen appreciation have been forcing traders to unwind their yen-carry trades. This might explain the rout in the global bond market since 2024. Japan’s bond market confirms the BOJ has more tightening to do. JGB yields have risen sharply alongside the policy rate but remain well above it across the curve (chart). Japan’s Bond Vigilantes are signaling that monetary policy remains too accommodative. Higher Japanese bond yields also encourage Japanese bond investors to return home and reduce their exposure to foreign bonds, especially if the yen continues to rally. The surge in the 10-year JGB yield has occurred alongside a broad rise in global government bond yields (chart). In our view, the unwinding of yen-funded positions may be a key contributor to the synchronized rise in these bond yields. Japan is leading the global bond selloff. Its 10-year yield is up 93bps this year, one of the largest increases globally (chart). We will be interested to see how the BOJ's rate decision affects global yields tomorrow. II. US Capital Flows Holdings of US Treasuries by all Japanese accounts (both private and official) have declined recently and appear to be trending lower (chart). The Japanese may be unwinding their overseas positions in global bonds too, as domestic yields rise, making JGBs more attractive again. Total private foreign purchases of US Treasury notes and bonds fell to $263.4 billion over the past 12 months, the lowest since 2022. Purchases of US corporate bonds totaled $392.3 billion over the past 12 months, as foreign investors increasingly favor investment-grade debt tied to the AI buildout (chart). The shift in the composition of foreign demand for US assets is also clear over the past three months through July. Equities attracted the largest inflows, followed by corporate bonds, while purchases of Treasury notes and bonds were much smaller (chart). Now get this: Over the past 12 months, foreigners purchased a record $941.9 billion in US equities (chart)! This includes $139.6 billion in US equity purchases by foreign official accounts over the past 12 months. In aggregate, private net foreign capital inflows into the US remained elevated at around $1.2 trillion over the past 12 months (chart). Net inflows from foreign official accounts totaled just $31.7 billion. III. US Economic Indicators The strength of the US economy remains the key reason private foreign inflows into US equities and corporate bonds are so strong. Here is a look: (1) Jobless claims. The US labor market remains in good shape. Initial jobless claims fell to 196,000 during the week of September 11 and have now come in below 200,000 five times this year, versus just once in 2025 (chart). Meanwhile, the four-week moving average of continuing claims fell to its lowest level since January 2024 and has declined for four consecutive weeks. (2) Consumer spending. After the August retail sales report showed consumer spending remained robust, Redbook data suggest that strength has carried into September. Same-store sales rose 8.4% y/y during the week of September 11, well above the 5.8% average in 2025 (chart). Bank of America’s August Consumer Checkpoint Survey also points to robust spending. Card spending per household rose 0.9% m/m and 4.5% y/y, more than four times the 2025 average. Excluding gasoline, spending rose 3.7% y/y, more than 2.5 times the 2025 pace. (3) Manufacturing. Economic activity in manufacturing also remains remarkably robust. The average of the New York and Philadelphia Fed manufacturing indexes remained elevated at 22.7 in September, suggesting the national M-PMI likely remained comfortably in expansion territory (chart). The regional prices-paid and prices-received indexes remained high, suggesting that inflation pressures remain troublesome (chart).
On Energy, Earnings & A New, Efficient Chip
Today, Jackie examines the causes and the ramifications of the oil supply shocks resulting from the Middle East war. The US Strategic Petroleum Reserve is believed to be about as low as it can go and still operate. With energy prices surging, energy-related industries are having a heyday. … Also: Industry analysts have had to play catch-up as S&P 500 companies seem bound for ever-stronger results. Joe reports that net estimate revisions for 2027, as for 2026, have been rising over time instead of falling as is typical. … And: A new kind of inference chip could curb data centers’ ravenous consumption of power and water.
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