It has been a volatile three months in the real world: the war in Iran remains ongoing, mortgage rates ticked above 7%, midterm elections are looming, and fears of an Artificial Intelligence-induced doomsday dominated the headlines. Against that backdrop, the US equity market was notably subdued, with the S&P 500 moving largely sideways and remaining within striking distance of all-time highs. Earnings remained the primary driver, with S&P 500 earnings now expected to grow a staggering 32% in 2026, almost exactly double the Street expectation only six short months ago. Although concerns about an “AI bubble” are warranted, the earnings outlook has improved markedly in recent months while the market barely budged, which is to say the US equity market valuation moderated in the third quarter.
Pluses and minuses of an AI-driven market
After years of hype regarding the benefits of artificial intelligence, media reports have shifted sharply negative recently, with descriptions of rogue agents hacking both rivals and governments alike, product launches being delayed over safety concerns, and company leaders calling for a slowdown in development. Not to mention predictions of society’s pending demise. Across the country, voters are making their voices heard, pushing back aggressively against data center development, while making AI regulation a leading issue ahead of the midterm elections.
Despite the relentless press coverage, corporate America and equity markets have largely downplayed these headlines and remained focused on the many benefits of artificial intelligence to the US economy. Elon Musk even went so far as to say that AI efficiency would mean that “saving for retirement will be irrelevant.” For the record, Howland Capital takes a decidedly different view!
The benefits to the US economy to date can be seen most clearly through the lens of earnings growth. While it is true that technology stocks have led the way, the infrastructure buildout required to power the “AI revolution” has driven outsized earnings growth across the market. Materials (+42%), financials (+22%), and industrials (+17%) are just three examples of non-tech related sectors delivering outsized earnings growth in the second quarter. Ten of the eleven sectors of the S&P 500 reported earnings growth of at least 9% during the second quarter, with health care notably the only outlier (earnings fell 6%). As mentioned above, third quarter earnings expectations remain upbeat.
Although earnings power has been widespread of late, the scope of the gains has not translated to market breadth, which retreated in the third quarter. During the last week of September, the median S&P 500 stock was down 16% from its 52-week high, while the broader equity market remained ~1% below record levels. This persistent disconnect has been an ongoing challenge for investors.
Outlook
Although we are mindful of the risks of an “AI bubble,” we remain generally constructive on the outlook for US equities. Economic growth remains steady even if not spectacular, which the market has favored historically. The Federal Reserve has shown its willingness to take the hard steps required to rein in inflation. Sentiment (as measured by market valuation) remains above historic averages but only appears to be truly stretched in a few small subsegments of the market. And prediction markets point to Democrats regaining control of at least one, if not both, houses of Congress; gridlock in Washington has historically been well received by markets.
Taken together, we believe the outlook for earnings growth remains favorable, and market strategists agree: the Wall Street consensus forecasts for S&P earnings now implies 15% growth in 2027 and 17% growth in 2028. Improvements in corporate profitability have been highly supportive of earnings growth of late, with the S&P 500 operating margin up more than 3% from pre-Covid levels. The drivers of those profitability improvements (e.g. AI-driven efficiency, pricing power, receding tariff fears) all remain in place and are likely to provide a tailwind over the medium-term. As we have written many times in the past, we believe that stocks follow earnings over the long-term; if so, the setup for equity markets remains favorable in our view.
Investing at all-time highs can be vexing, but it has not proven to be a significant drag on returns over time. In fact, not being invested has been a far more meaningful detractor. It is also worth noting that this current bull market is perhaps not as unusual as it seems. Bull markets historically have lasted five years on average, with a median S&P 500 return of roughly 180% over that period. This current bull market began almost exactly four years ago, with a return so far of 115%. We are living in exciting, but not unprecedented, times.
All that said, global markets do not move in straight lines, and drawdowns and volatility are to be expected in the months and years ahead. Our outlook remains constructive, but balanced, which we believe aligns well with the investment approach we strive for at Howland Capital. We will continue to work to identify high quality companies across all market sectors, and we believe our portfolios should benefit from improved market breadth over time. And our buy and hold approach allows us to remain fully invested through periods of market volatility.
