BakerAvenue Prudence Indicator Says...
Long Term: Positive | Short Term: Neutral
Higher Rate Hurdle, but Earnings Clearing the Bar
"Pressure is a privilege."
- Billie Jean King
A backup in global interest rates has raised the cost of capital and pressured valuations. 10-year Treasury yields have risen by over 1% since the start of the year and 1.3% since the year-to-date lows set on the eve of the US-Iran conflict, reaching multi-decade highs. From a global standpoint, the backup in bond yields since late August has come in two phases. The first was influenced by central bank decisions and the second, which covers the last month or so, has coincided with greater stress in sovereign spreads (e.g., France). Elevated inflation has played a role as well. And, importantly, so has the resilient economic growth backdrop.
Markets have pushed to new highs as the surge in corporate earnings has continued with estimates creeping higher despite higher rates (and oil prices). Profit margins are at record levels, with strong demand from the AI boom and tariff refunds both helping to drive up profitability to unprecedented levels this year. We continue to see upside to revenue and earnings estimates, helping to neutralize the impacts of higher rates.
Our investment process is built to remove emotion from portfolio decisions. At BakerAvenue, we maintain analytical independence from pre-written market narratives. We remove preconceived biases and defer to our analytical output. Ultimately, our views are only as optimistic or pessimistic as our technical, macro, and fundamental analyses indicate. Currently, our short-term metrics are in a neutral position while our longer-term view is positive.
For those who have been following our market updates (view previous market update videos and commentaries), you will be familiar with several of our key concerns and opportunities. We have continually stated our expectations of moderate growth. There are plenty of adjustments to consider, but our overarching views remain the same. Ultimately, economic and earnings growth will support a grind higher in equities. We believe it is a good time to be active and want to be thoughtful regarding portfolio construction and risk control.
The Technical Perspective
Price trends remain constructive, with the S&P 500 setting a fresh series of all-time highs while both its 100-day and 200-day moving averages slope upward and sit comfortably below current levels. Leadership has seen a series of rotations, but the backdrop is not distributive (an important distinction). We are intently focused on leadership establishment as we consider tactical portfolio tilts. The more notable development, in our view, is that rolling correlations among S&P 500 constituents have fallen near an all-time low, and single-stock volatility and dispersion have risen accordingly (e.g., a 'market of stocks, rather than a stock market').
We are watching for a sustained momentum thrust to help the market extend, or at minimum defend, its highs during this seasonally volatile stretch. Internals have plenty of room for improvement with only 45% of S&P 500 constituents above their 200-day moving average. Encouragingly, sentiment reads remain constructive for the bull case precisely because they are unremarkable; bull-bear surveys register a neutral bias rather than euphoria, and bull markets tend to die on euphoria, not skepticism. Elevated money market balances continue to provide a buffer against sizable pullbacks. While the bar for adding equity exposure is higher than it was in an era of near-zero rates, our view remains that investors have room to increase allocations, particularly as lower stock-to-stock correlation widens the opportunity set for disciplined, active security selection.
The Macro Perspective
Economic growth remains resilient on balance: 2026 GDP growth is tracking around 2.5% with estimates for 2027 around the same levels. Incoming economic data continues to surprise to the upside on net. The industrial economy remains a particular area of focus for us, as a beneficiary of increased capital spending, favorable tax treatment, and re-shoring trends, all of which bode well for broad market profitability. Geopolitical and policy risk has picked up, most notably around midterm election positioning. We expect the midterms to produce few material legislative changes and thus limited broad market influence, though sector- and industry-specific impacts (e.g., around data center and AI infrastructure policy) are more likely. The Iran conflict remains kinetic with both sides negotiating while simultaneously attempting to raise the cost of failure; we continue to think the worst is behind us.
We are mindful of the rate impacts on the capital markets. Encouragingly, the current rate backdrop, while elevated relative to post-pandemic lows, remains modest relative to the 10-year yield’s 50-year average (5.3% currently vs. 5.9% on average). We continue to view it as manageable provided economic growth remains intact. The Treasury has also signaled limited tolerance for a further, disorderly rise in long-term rates, an important backstop for risk assets.
The Fundamental Perspective
Corporate fundamentals remain in good shape, and we continue to see upside to consensus earnings and revenue estimates. Third-quarter S&P 500 earnings grew 33% year-over-year, nearly 11 points ahead of the consensus estimates. Forward guidance was equally impressive, with the share of companies raising present-quarter guidance near its highest level since the pandemic. Profit margins remain near record levels, an encouraging sign of pricing power and cost discipline even amid an uncertain macro backdrop. Importantly, growth is broadening beyond the Magnificent Seven: earnings growth for the 'remaining 493' companies is accelerating into the high-20% range through 2027 even as Magnificent Seven growth decelerates from last year’s 40%-plus pace, a convergence that should support improved market breadth.
Valuations have come down and remain reasonable on balance: the equal-weighted S&P 500’s forward price-to-earnings ratio sits at roughly 15x, essentially in line with its long-term average. On balance, credit spreads remain well-behaved and supportive of risk assets, a key input to our risk management process. The backup in rates has yet to materially impact the credit backdrop. On the AI capital spending debate specifically, we continue to view recent weakness in AI infrastructure-related names as reflecting positioning and technical factors rather than deteriorating fundamentals. We are aware of the scale of the hyperscalers' purchase commitments, now roughly $1.5 trillion, and circular financing concerns. However, we continue to see demand outstripping supply as the early returns on that investment start to accrue. We will be diligent in our exposure here.
Concluding Thoughts
The backup in global interest rates has raised the cost of capital and pressured valuations. Encouragingly, the economic growth backdrop has remained resilient and earnings growth historically robust. We are risk aware, particularly related to interest rates, but factors within our technical, macro, and fundamental disciplines continue to skew positively on balance. As we approach a seasonally volatile stretch, we remain constructive as growth resiliency has proven sustainable.
Our investment philosophy is based on a dual mandate of growing and protecting client assets. We continue to focus on 'how' one is positioned, not 'if' they should have exposure at all. We are staying active, using volatility to harvest losses while opportunistically deploying capital where appropriate. At this point, our cash weightings remain residual in nature, and we are focusing on strategy positioning vs. our respective benchmarks to control risk. Of course, should the backdrop destabilize, we will take a more defensive stance.
Should you have any questions or comments, please contact BakerAvenue. We are happy to share our thoughts in greater detail, and we welcome the opportunity to speak with you.
Disclosure: Past performance is not indicative of future performance.