The bull market has a new problem: Capital is becoming more expensive just as the AI buildout requires unprecedented amounts of it.
What’s influencing the stock market right now?
Earnings remain remarkably strong, growing 38% over the past year, and analysts continue to raise their expectations for future earnings. But growth of 30% or 40% cannot continue indefinitely. Even if earnings keep climbing, investors may become less willing to pay top prices if they believe the fastest growth is behind them.
At the same time, the headwinds have picked up. Oil is adding to inflation pressures, inflation is keeping interest rates higher, and the Fed is tightening again. As of early October, long-term Treasury yields were above 5%, giving investors an attractive alternative to stocks and putting downward pressure on valuations, or the prices investors are willing to pay for company earnings.
The enormous demand for capital adds another dimension. We have never had a technological revolution this hungry for money. AI infrastructure, data centers, power generation, and the electric grid all require substantial investment, and hyperscalers are raising enormous sums to finance that buildout.
That does not mean the AI story is unsound. The earnings are real, and the technology may ultimately become even more important than investors expect. But the promise of the technology and the investment prospects of the companies funding it are not necessarily the same thing.
Today’s market does not have the same earnings and valuation problems as the dot-com bubble. But it may eventually confront a question of financial plumbing: How much money can be raised and deployed before the rising cost of capital begins to constrain the cycle?
None of this has to end the bull market. But it could change its trajectory. One of the most important forces to watch now is the rise in real interest rates, which is beginning to affect not only stock valuations but also the broader economy.
Why are real rates important for the stock market?
Real interest rates, which measure interest rates after accounting for inflation, have recently moved above many estimates of the economy’s long-term growth rate. That may sound abstract, but the logic is fairly straightforward.
Imagine you’re an entrepreneur who takes out a loan at 8%. If your business is growing 30% a year, that borrowing cost probably isn’t a problem. Growth more than covers the cost of the debt. But if the business is growing only 2%, the math starts working against you. Over time, servicing that debt becomes much more difficult.
The same principle applies to the broader economy.
Economists often assess the economy’s capacity to carry debt by looking at potential GDP, or the pace at which the economy can grow without generating excessive inflation. Potential GDP is largely determined by 2 things: growth in the labor force and gains in productivity.
Today, estimates of potential real GDP growth, adjusted for inflation, generally fall between 2% and 2.5%. Meanwhile, the real yield on the 10-year Treasury, which reflects the return investors can earn after accounting for inflation, is around 2.8%.
In other words, an important benchmark for the inflation-adjusted cost of capital has moved above the economy’s estimated sustainable growth rate.
That relationship has emerged only recently, so it’s too early to draw a firm conclusion. It could also change if AI produces a significant increase in productivity, raising the economy’s speed limit.
Still, the crossover is worth watching. When the inflation-adjusted cost of capital exceeds the rate at which the economy can sustainably grow, debt becomes harder to carry. Over time, that can weigh on borrowing, investment, and economic growth, while putting additional pressure on the companies and borrowers with the weakest balance sheets.
Fed rate hikes don't necessarily kill a bull market, but they often show up at the scene of the crime when one ends. That's because higher rates eventually work their way through the economy, affecting borrowing costs, valuations, and the availability of capital.
Strength at the top, strain underneath
That pressure is not being felt evenly. The major indexes remain near the all-time highs they set in August, but conditions beneath the surface tell a more complicated story. Less than half of the stocks in the S&P 500 are currently in uptrends, and only about a quarter are above their 50-day moving averages, as of the beginning of October. That suggests the headline indexes may be masking growing pressure on individual companies.
Part of that divide comes down to financial strength. The largest technology companies generate substantial cash and can continue investing even as capital becomes more expensive. Smaller or more leveraged companies have less room to maneuver.
That distinction could become increasingly important as companies that refinanced their debt at very low rates in 2020 and 2021 approach a wall of upcoming maturities. Refinancing that debt at today’s higher rates could put additional pressure on weaker businesses, even if the broader credit markets remain stable.
The pressure is already being felt unevenly. The strongest companies remain relatively insulated, while the weaker ones are beginning to feel the pinch from a higher cost of capital. The coming wave of refinancing could widen that divide.
An echo of 2022?
One way I think about today’s environment is as a potential aftershock of 2022.
The comparison isn’t about earnings. Earnings growth is significantly stronger today than it was then. The similarity is the pressure from interest rates: Higher rates can offset some of the benefit of rising earnings by pushing valuations lower.
Once again, the market is trying to balance a falling P/E ratio against a rising E, or earnings.
Consider a simplified example. If earnings grow 30% while the market’s P/E ratio falls 20%, stock prices could still rise, but by much less than earnings alone might suggest.
That may be the kind of market we’re facing: not necessarily a bear market, but a bull market with a lower slope. Earnings could continue to push stocks higher, while falling valuations absorb part of the gain.
That would still be a bull market. It just might look more like annual returns of 7% or 10% rather than the 20%-plus gains investors have recently experienced.
What investors can learn from this
A bull market with a lower slope calls for a different set of expectations and, potentially, a different approach.
For much of the past 17 years, investors were rewarded simply for owning the market. Broad market exposure produced unusually strong returns, without investors necessarily needing to be highly selective.
History suggests investors should not assume that experience will continue indefinitely. Markets tend to revert to the mean, and the forces that drove returns during one period rarely persist in a straight line.
The good news is that investors have more choices today than they did a few years ago. The world is your oyster. Global markets have become more competitive, bonds once again offer meaningful income, and diversification may provide benefits that were harder to appreciate when a small group of large US technology stocks dominated returns. Read Viewpoints: The new diversification
Against that backdrop, I find myself asking a simple question: Is this the moment to become more aggressive, or is it a time to rebalance and make sure a portfolio remains properly diversified?
My view is that this may be a time to rebalance rather than reach for more risk. That could mean looking beyond the largest US technology companies, considering global markets and parts of the US market that are less dependent on AI, and recognizing the role bonds can once again play in generating income and balancing equity risk.
Diversification didn’t always feel rewarding when a small group of US stocks was driving the market higher. But the conditions that made concentrated exposure so successful may also be among the least likely to repeat indefinitely.
The lesson is not to become bearish. It is not to get over your skis.
The bull market may continue, but the investing landscape has changed. Investors may want to embrace that reality by staying diversified, rebalancing where appropriate, and setting realistic expectations for the kinds of returns the next chapter may bring.