The end of summer is punctuated by the Federal Reserve’s annual confab in Jackson Hole, Wyoming. Chair Powell’s speech at this event is always much anticipated and this year was no different as investors listened for clues for if and when the Fed would cut interest rates. Investors interpreted his comments on Friday as dovish and both the stock and bond markets rallied strongly on higher expectations for a 25bps rate cut at the September meeting. The Fed Futures market now reflects an 80+% chance of a cut[1].
There were several comments in the speech worth pointing out:
“In the near term, risks to inflation are tilted to the upside, and risks to employment to the downside – a challenging situation.”[2] This statement implies that the voting members remain concerned that inflation could increase in the near future as higher tariff-related prices work their way through supply chains. While stopping short of re-using the now maligned term “transitory”, the Fed’s “base case”, according to Powell, is that tariff-induced inflation would be “short-lived”. This implies that the Fed is unlikely to raise rates in the face of higher goods inflation.
As for the labor market, the big downward revisions to the May and June payrolls raised concerns that jobs are not as plentiful. The chart below shows the additions to non-farm payrolls over the last year using a three-month average to take out some of the monthly noise[3]. (Powell used this chart in his speech.) The chart quite clearly shows a declining number of jobs being added to the economy in recent months. Powell noted that the “downside risks to employment are rising”. This may be the case; however, it is also possible that tariff fears have weighed on hiring plans over the last five months and that the small rebound witnessed in July is the beginning of a reacceleration in job growth as tariff clarity is understood.
Source: Bureau of Labor Statistics
Powell concluded, “Nonetheless, with policy in restrictive territory, the baseline outlook and the shifting balance of risks may warrant adjusting our policy stance.” He is saying that given a weakening labor market, we may cut rates. This is a critical point that we have talked about for months. In our opinion, the current level of interest rates is approximately 100 bps too restrictive, which means rates are a drag on economic growth. It also means that the Fed has room to cut interest rates and still be restrictive enough to defend against tariff-induced inflation. With increasing risks to the labor market, it appears that the Fed is likely to cut 25 bps in September.
Lower Rates Fuel the Bull Market
A gradual easing of interest rates would create a tailwind for the stock and bond markets because lower rates will likely stimulate economic growth. Stocks benefit from lower borrowing costs, improved earnings, and higher valuations. Bonds typically see price appreciation as yields fall. Consumers will finally get some relief, particularly those who carry credit card balances and student loans. In short, lower rates could help propel the current bull market into 2026.
Some market critics have pointed out that market valuations are too high. The S&P 500 currently trades at 22.4x next-twelve-months earnings estimates[4]. That price-to-earnings ratio is historically high and approaching the peak set during the heady DotCom days of 25.1x. However, this does not tell the whole story. As the chart below shows, it is crucial to separate the Magnificent 7 from the Other 493 stocks in the index. The Magnificent 7 are not fully valued in our view but they do trade at much higher multiples than the rest of the market given their extraordinary characteristics. Given the market cap weighting of the index and the size of the Magnificent 7, the overall index PE is higher relative to other periods in history due to mix.
Historically, markets do not decline because valuations get too high. They decline because earnings growth expectations worsen. The chart below shows the earnings expectations for the next twelve months for the Magnificent 7 and the Other 493. The Magnificent 7’s estimates have experienced a steady increase all year indicating improving fortunes. The Other 493 have experienced a rockier road this year with tariffs fears dragging down earnings expectations during April and May. However, those fears proved overblown and earnings estimates are now even higher than the pre-tariff period peak.
Going forward, it is reasonable to be optimistic about further earnings growth. Not only would lower interest rates be beneficial, but stimulus from the Big Beautiful Bill, deregulation and AI implementation will likely create further tailwinds. In addition to lower taxes, the Big Beautiful Bill provides significant tax incentives for companies to develop new facilities. Already companies have pledged over $3 trillion in aggregate investments to build and expand facilities in the U.S[5]. The job creation opportunity is potentially enormous.
Additionally, deregulation promises to eliminate barriers to growth. These actions can facilitate construction projects, energy production, bank lending and many other potentially beneficial areas of economic growth.
Furthermore, business adoption of AI could boost revenues for many companies and drive efficiencies for others. We do not believe that earnings estimates today reflect much benefit from AI.
Portfolio Strategy
We continue to be quite upbeat about the market. Much of the uncertainties that plagued markets earlier this year are in the rear-view mirror. A lot of groundwork for economic growth has been laid and there are very powerful themes such as AI, electrification and many others that are transforming industries. This is a truly unique moment. From bitcoin to AI data centers to increase electricity generation, these are truly unique times. As mentioned above, businesses have barely scratched the surface in using AI. On the horizon, there are new applications such as robotics, which could be transformative. Imagine having an army of robots building products 24/7. Many of our investment themes are still in their early innings, so we are excited about the future.
That said, the market and many of our positions have had a good run since the market bottom in April. We have been disciplined in trimming winners and tax loss harvesting losers to the extent we have any. We know the market could easily pull back 5% if only on profit taking. As a tactical manager, we will adapt, as necessary. For our portfolios, interest rate cuts would be helpful but not integral for return generation. As we are invested in powerful secular themes, such as AI, electrification, defense spending, liquified natural gas exports and others, the stocks we own benefit from multi-year, sweeping secular trends that are likely to accelerate their earnings profiles.
From a fixed income perspective, interest rate cuts will have several beneficial effects. Broadly speaking, lower rates equal higher bond prices, which would create a tailwind across the yield curve. The short end of the curve will show the most dramatic impact, which will likely steepen the yield curve. Outside of our bond holdings, a steeper yield curve will help our financial services holdings. Further, at some point, interest rates could decline over the next year to a level where holders of market market funds may need to put their money into higher yields further out the yield curve or even into stocks, particularly those with attractive dividend yields. Come what may, we are delighted that fixed income investments are finally delivering solid returns to investors. The Bloomberg US Aggregate Bond Index, for instance, is up nearly 5% YTD. This is a particularly beneficial environment for our more conservative investors.
Conclusion
Barring some unforeseen externality, the economy remains solid, and the Fed seems to be in an easing mood. While the labor market seems a bit weaker, with trade deals largely in place companies may re-accelerate hiring. There are several other positive economic tailwinds, such lower taxes and more investment spending mentioned above, that are just beginning to have effect. Secular themes, such as AI adoption, are truly transformational and we are in the early innings of seeing their impact. We are not pollyannish; however, we observe and assess economic and market data and adjust when necessary. That is one of the benefits of tactical investing.
Finally, we hope you saw our announcement on LinkedIn, that our Global Vigilance Moderate and Global Vigilance Tilt strategies earned the Zephyr PSN Top Gun recognition. The PSN Top Gun rating for the strategies was awarded on August 19th for their one-year and most recent quarter performance within the Global / International Balanced universe. The recognition reflects the hard work, discipline, and commitment of our investment team to deliver strong, consistent results for our clients[6].
Disclosures
LIM is an Investment Advisor based in Dallas, Texas and registered with the Securities and Exchange Commission. Registration does not imply a certain level of skills or training. LIM is a company with purpose, dedicated to creative and unique thinking. We focus on portfolio valuation and research, along with superior client experience. We seek to identify investment opportunities by looking at economic factors, security valuation and human behavior. We start with the fundamentals of portfolio management and valuation. Then we build on these fundamentals with unique thinking and creative intelligence gathering to form a viable investment thesis. We believe this approach leads to dynamic global portfolios with increased return and managed risk. LIM utilizes Charles Schwab & Co. Inc. (“Schwab”), a FINRA-registered broker-dealer, member SIPC, as its custodian of assets. LIM is independently owned and operated and not affiliated with Schwab.
Additional disclosures:
This document may contain forward-looking statements based on LIM’s expectations and projections about the methods by which it expects to invest. Those statements are sometimes indicated by words such as “expects,” “believes,” “will” and similar expressions. In addition, any statements that refer to expectations, projections or characterizations of future events or circumstances, including any underlying assumptions, are forward-looking statements. Such statements are not guaranties of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, actual returns could differ materially and adversely from those expressed or implied in any forward-looking statements as a result of various factors.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results.
Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions.
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Definitions
The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market-value weighted index (stock price times number of shares outstanding), with each stock’s weight in the Index proportionate to its market value.
The Nasdaq Composite Index is a market cap-weighted index, representing the value of all stocks listed on the Nasdaq Stock Market. The composition of the Nasdaq Composite is a mix of long-established companies that have been on the exchange since inception, to IPO newcomers, companies that grew from OTC exchanges or switched from other exchanges.
The Dow Jones Industrial Average is a price-weighted average of 30 blue-chip stocks that are generally the leaders in their industry. It has been a widely followed indicator of the stock market since October 1, 1928.
The Bloomberg US Aggregate Index is a broad-based flagship benchmark that measures the investment grade, US dollar-dominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate pass throughs), asset-backed securities, and commercial mortgage-backed securities.
The S&P 500 Equal Weighted Index is the equal-weight version of the S&P 500. The index includes the same constituents as the capitalization weighted S&P 500 index, but each company is allocated the same fixed weight at each quarterly rebalance.
The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 Index total market capitalization.