All of the Charts Are Green – Christian’s Q3 Market Commentary

• The S&P 500 gained 14.9% in Q2, its best quarter since 2020, powered by record earnings growth and the rare sight of analysts raising estimates mid-quarter rather than cutting them.
• The rally has broadened beyond the Magnificent 7 (now the “Lag 7”) to small caps, mid caps, and emerging markets, an outcome we called for in our January predictions.

• We see three risks for the second half: a Fed that has swung from pricing cuts to pricing hikes, a peace deal with Iran the market is treating as finished, and mean reversion in earnings estimates if AI spending moderates.
• We don’t expect the worst case in any of the three. We remain bullish but expect a choppier quarter with lower returns as leadership continues to hand off to smaller companies and unloved sectors.

Earlier this year I read American Icon, Bryce Hoffman’s account of how Alan Mulally saved Ford Motor Company, and one scene has stayed with me for months.

When Mulally arrived from Boeing in late 2006, Ford was forecasting a loss of $17 billion for the year, the worst in the company’s century of existence. One of his first changes was a mandatory Thursday morning meeting where every executive had to color-code the status of their operations: green for on track, yellow for at risk, red for in trouble. Week after week, the leaders of a company hemorrhaging billions stood up and presented wall-to-wall green. Finally, Mulally asked the obvious question: we are going to lose seventeen billion dollars this year, so is there anything that’s not going well here?

Nobody raised a hand. At Ford, admitting a problem had always been the fastest way to lose your job, so nobody admitted problems. They just had them.

A few weeks later, Mark Fields, who ran the Americas, decided to test whether Mulally meant it. The launch of the new Ford Edge was in trouble, and Fields turned his chart red. The room went quiet, waiting to see if he’d be fired. Instead, Mulally started clapping. Within weeks the charts turned into rainbows, problems started getting solved instead of hidden, and Ford went on to become the only Detroit automaker to survive the financial crisis without a bailout or bankruptcy.

Mulally’s point was simple: you can’t manage a problem nobody will name, and the most dangerous time to have one is when everything looks green. The second quarter of 2026 was one of the greenest quarters investors have seen in years. I want to enjoy that honestly, and then do what Ford’s executives couldn’t at first: put our yellows on the table while things are still going well.

Every market commentary we write eventually comes back to the same sentence: corporate earnings are the primary driver of long-term stock returns. First quarter earnings for the S&P 500 grew 29% year over year on revenue growth of nearly 12%, the strongest profit growth since 2021. But the number that jumped out to me is what happened to expectations for the second quarter while it was still underway.

In a normal quarter, analysts start out optimistic and walk their numbers down as reality arrives. Over the past ten years, second-quarter estimates have fallen an average of 2.7% between April and June. This year however, they rose 3.4%, pushing expected Q2 growth from 18.8% to over 23%, and 63 companies issued positive guidance, the most since 2021. Analysts now project full-year 2026 profit growth of around 24%, the best since the post-COVID rebound.

A market rising 15% on top of rising earnings estimates is fundamentally healthier than one rising 15% on multiple expansion alone. (Multiple expansion means stocks getting more expensive. An example to explain this: a stock’s price going up from trading at 20x earnings to 22x earnings is not as good as a stock continuing to trade at 20x earnings but the earnings increasing.) This rally has a profit base underneath it. That’s what has gone right, and it’s also the thing most exposed if the AI spending cycle stumbles, which we’ll get to.

In January we predicted small caps would outperform large caps for the first time since 2020, and that emerging markets, particularly China and the beaten-down corners of Asia, would outperform the U.S. on the simple logic that when expectations are low enough, outcomes only need to be less bad than feared. Halfway through the year, both calls are working.

The Magnificent 7 have collectively underperformed the S&P 500 all year, enough to earn a new nickname in the financial press: the Lag 7. That isn’t a story of those businesses deteriorating, since their earnings are still growing. It’s a story of the rest of the market finally participating. In the first quarter, while the headline S&P 500 fell 4.3%, the equal-weighted index and the Russell 2000 each gained about 1%, and that leadership carried through the second quarter’s rally.

The AI trade itself has broadened too. Two years ago, owning AI meant owning seven stocks. Today the biggest beneficiaries include semiconductor and memory companies, the industrials and utilities building and powering data centers, and a wave of Asian chipmakers that helped power emerging markets to a 34% return in 2025 against 18% for the S&P 500, an outperformance that has continued into 2026, driven mostly by earnings growth. A rally where the winners come from all over stands on much firmer ground than one carried by seven stocks.

So, the first half delivered record earnings and record highs, with more of the market participating than we’ve seen in years. The charts are green. Now for the part of the meeting where we earn our keep: three yellows for the second half, and none of them are hiding.

The swing in interest rate expectations this year has been enormous. In January, markets were pricing in two rate cuts for 2026. Today, futures markets price in better than a 75% chance of at least one hike before year-end, and Bank of America is forecasting three. That’s roughly a full percentage point swing in expectations in six months.

The inflation data explains why. Headline CPI hit 4.2% in May, a three-year high, driven largely by the energy spike from the war, and core PCE, the Fed’s preferred gauge, sits at 3.4%. It’s worth remembering that inflation was above target before the first missile flew. Meanwhile the labor market has refused to provide cover for cuts, with unemployment holding steady around 4.3% and hiring actually firming in recent months. An economy with 4% inflation and a stable job market is not one that gets rate cuts.

Then there is the new chairman. President Trump appointed Kevin Warsh presumably hoping for a more accommodating Fed. What he got, at least so far, is the opposite, for two reasons. First, the chairman is one vote among twelve. Second, and more interesting, Warsh’s signature reform is talking less. He struck forward guidance from the policy statement, declined to submit his own rate projection, and shortened the press conference. When the chair stops filling the airwaves, the rest of the committee fills the void, and this committee has moved decisively hawkish: at the June meeting, nearly half of the nineteen policymakers penciled in higher rates for 2026, versus zero in March. And when Warsh himself did speak, his message was six words: “The Committee will deliver price stability.” He has repeated it in the weeks since, mentioning inflation constantly and employment barely at all.

Here’s what we think the market is underestimating. Futures are pricing something like one or two hikes, but the Fed rarely hikes once or twice. Historically, they either stay on hold or they embark on a full cycle, which means the range of outcomes isn’t centered where the market has priced it. Either the Fed holds through year end, a positive surprise, or it starts hiking and probably doesn’t stop at two, a negative one. Our view is that the committee will try to stay on hold as long as it can, letting falling energy prices do the disinflation work for them. But if core inflation doesn’t make visible progress toward 2% soon, we think Warsh has told us exactly what he’ll do. We take him at his word.

We’ll admit our January prediction of second-half rate cuts is in serious jeopardy. Being wrong comes with the territory in this business. Refusing to update when the facts change is the bigger mistake, and the facts have changed.

The interim agreement between the U.S. and Iran, signed in June, reopened the Strait of Hormuz and set a 60-day clock for a final deal. Markets celebrated, and rightly so. By early July, WTI had drifted to around $70 a barrel, essentially back to where it sat before the war began, down from over $120 at the peak. Oil is where the war premium lives, and at $70 there was almost no premium left. That was the market’s way of saying it considered the conflict over.

Then, in the first week of July, that judgment got tested. Iran attacked three commercial vessels in the Strait, the U.S. responded with two nights of strikes on Iranian targets, Iran hit American bases in the region, and President Trump declared at the NATO summit that as far as he’s concerned, the ceasefire is over and negotiating with Iran is a waste of time. And yet look at oil’s reaction: WTI jumped to the mid-$70s, then gave some of it back within a day. Renewed fighting and a presidential declaration that the deal is dead were worth about five dollars a barrel. The market is scoring this as a negotiating tactic rather than a return to February, and it may well be right. Both sides still have strong incentives to finish the deal, with midterms approaching for President Trump and frozen assets and sanctions relief on the table for Iran. A deal remains our base case.

But that flare-up is exactly why we flag the risk. There’s an old rule of markets worth repeating here: the market can’t be badly hurt by something it’s watching for, but it can be badly hurt by something it has stopped watching for. In February, nobody was pricing a war, and the S&P fell into a correction when one arrived. As of this writing, oil in the mid-$70s is pricing a spat that gets resolved, so if the flare-up hardens into a real collapse of the peace process, the move in oil, inflation expectations, and rate expectations would be swift. We aren’t predicting that outcome. But insurance is cheapest when nobody thinks they need it, which is part of why we still hold our energy position after trimming the crisis premium it earned in the first quarter.

The upward revisions we celebrated a few pages ago have a flip side. When estimates rise faster than they ever have, the bar for disappointment gets set at a height nobody has cleared before. And much of the earnings strength traces back to one thing: AI infrastructure spending. The five largest spenders are on track to pour $600 to $700 billion into capital expenditures this year, up more than a third from 2025. As a group, the hyperscalers are now spending roughly 90% of their operating cash flow on capex, up from about 65% a year ago, with more of the buildout financed by debt and equity rather than retained earnings.

The hyperscalers insist they aren’t slowing down. We believe them, for now. But the shareholders funding all of this are getting restless. Oracle fell roughly 35% in June after reporting strong results, because those results came with a free cash flow deficit of more than $20 billion and a swelling debt load. Meta dropped sharply after a quarter in which earnings grew over 60%, because management raised capex guidance again. (Capex is capital expenditures guidance. Every quarter on their earnings call the company’s management announces how much they plan to spend on capital expenditures going forward and they keep raising that amount on AI-related investments.) It’s worth sitting with that for a second: the market punished 60% earnings growth. The message from investors has shifted from “spend whatever it takes” to “show us the return.”

The chain of events we worry about goes like this. If stock prices keep penalizing heavy spenders, boards eventually respond, because that’s what boards do. A moderation in AI capex, even a modest one, wouldn’t just affect seven companies. It would flow through the semiconductors, industrials, utilities, and everyone else in the data center buildout. Estimates that went up faster than ever can come down the same way, and we think they probably do, at least somewhat, in the back half of the year. That wouldn’t be a catastrophe, just normal mean reversion. But a market trading at more than 21 times forward earnings, above both its five and ten-year averages, has left itself little room for the estimates to be wrong.

None of these three risks is binary, and none of them operates on a schedule. Our expectation is that the perceived probability of each rises and falls as data arrives: an ugly inflation print here, a tense headline out of the Iran talks there, a cautious word from a hyperscaler CFO somewhere else. When one flares, the market will fixate on it, and we’ll get selloffs that feel significant in the moment. But our view is that the worst case doesn’t materialize in any of the three. The Fed tries hard to stay on hold, the peace deal gets done despite a noisy path, and AI spending moderates rather than collapses. If that’s roughly right, we remain in a bull market, even if the second half offers lower returns and a bumpier ride than the 15% quarter we just enjoyed.

Where we expect to be rewarded is in the continuation of the handoff, with leadership passing from the Magnificent 7 and the semiconductor complex to small and mid-cap stocks, international and emerging markets, and beneficiaries in previously unloved sectors.

Healthcare stands out to us here: it’s the only sector expected to report an earnings decline this quarter, expectations are on the floor. Our past experiences have shown that this situation can present potential entry points. A rally where more names and more sectors participate may present challenges, but we are prepared to navigate them.

So, consider this letter our version of Mulally’s Thursday morning meeting. Most of the charts are green, and we’ve flagged three yellows we’re watching closely, none of which we expect to turn red. The point of naming them now is the same as it was at Ford: problems you acknowledge while things are going well are problems you can manage. It’s important to pay attention to all the charts, not just the ones that are green every week.

Please do not hesitate to reach out with any questions, and I am happy to go deeper on how your specific portfolio is positioned through all of this.

Christian