According to Morgan Stanley, median year-on-year earnings growth across the Russell 3000 index — a more broad-based gauge of the US stock market than the S&P 500 — reached 11% in the third quarter, up from roughly 6% in the previous three months. This is the strongest performance since late 2021.
Yet investors seem unimpressed. Through the last month the S&P 500 has stayed largely flat. Those that were falling head over heels for every loss-making tech stock only a few weeks ago are now suddenly playing hard to get.
Such a reaction might seem counterintuitive, but it reflects a familiar paradox; strong earnings do not always translate into higher stock prices, at least when valuations are already stretched and priced for perfection. Instead, markets shrug.
Big Tech suddenly looking stretched
The latest bout of volatility and anxiety has been concentrated in the most prized and most expensive sector: Big Tech. Companies most closely associated with AI saw nearly $1-trillion wiped off their market caps last week, in the worst rout for tech shares since Trump’s Liberation Day tariff announcement chaos in April. Briefly staging a comeback early this week, they remain volatile.
The “Magnificent Seven” — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla — have for several years driven much of the stock market’s gains. This is for good reason; their earnings-per-share growth has far outpaced that of the other 493 firms that make up the S&P 500, a gap particularly pronounced last year, when Nvidia and Meta delivered outsized profit surges amid general middling performance from the rest of the market.
But that exceptionalism is now under strain. The costs of pursuing AI, or in its latest iterations “artificial general intelligence”, or even “superintelligence” (no one seems to have any idea what any of this means, least of all the tech firms themselves), are squeezing margins. In the third quarter alone, Alphabet, Amazon, Meta and Microsoft together spent $112-billion on capital expenditure.
These sums are staggering, even by Silicon Valley standards. If AI can be compared to alchemy, the fruitless quest to turn lead into gold, then it is proving an expensive hobby. The sector is borrowing heavily to fund its expansion, betting that AI will deliver future profits large enough to justify the splurge. Investors, once content to give the benefit of doubt to the narcissists who run these companies, are now more cautious.
Flying blind
Worries about the future of Big Tech coincide with renewed jitters on the state of the broader economy. The University of Michigan’s index of consumer sentiment fell in November to its lowest level in three years. Many will shrug and say who cares; for much of the post-pandemic period bad readings on consumer sentiment have been completely at odds with actual spending and economic activity across the US, and certainly not a reliable guide to market performance.
But this time the pessimism is compounded by political dysfunction and lack of other data. The longest government shutdown is clearly weighing on consumer and investor confidence. Although there are signs of a détente and a deal coming out of the Senate this week, with the Democrats supposedly backing down on their healthcare demands, the freeze in federal spending has already deprived markets of critical information. With statistical agencies closed, official data on employment and inflation have been either delayed or unavailable.
“We’re flying blind,” admitted Jerome Powell, the chairperson of the Federal Reserve.
In the absence of government data, investors have turned to private proxies, particularly on employment. And this has not inspired much cheer; Goldman Sachs estimates that 17 S&P 500 companies, including Amazon, UPS and Target, have announced a combined 80,000 job cuts since September. Analysts have commented that these are largely white-collar and entry-level roles that are most vulnerable to AI-driven automation.
Retail fatigue
Retail investors, a potent force since the pandemic, are showing signs of fatigue. Flush with stimulus cash in 2020-2021, they piled into equities and crypto, amplifying every rebound. Now, with valuations lofty and liquidity ever scarcer, their enthusiasm appears to be waning. The market’s recent reaction to earnings — punishing Meta for weaker margins while rewarding Alphabet for more cautious spending and focusing on cash flow — suggests a reassertion of discipline.
Even the theatrics of Palantir’s results failed to impress. Its mercurial CEO Alex Karp hailed the company’s latest numbers as “the best results that any software company has ever delivered”, and portrayed Palantir as a champion of free speech and an “anti-woke” ally of the American “war-fighter”, whatever that is. Investors baulked, sending the shares down almost 20%. They have since staged a modest comeback.
A further warning comes from the crypto market. In barely a month Bitcoin fell from a record high of $126,000 to below $100,000 — a fall of more than 20% that erased more than $1-trillion from the broader crypto sector . The slide, triggered by a cascade of leveraged liquidations in mid-October, has left the world’s largest digital asset with year-to-date gains of roughly 10%, underperforming equities and even many bonds. Some traders see signs of stabilisation near the $100,000 mark, but the speed of the decline has rattled even committed crypto enthusiasts.
Strategists at Richard Bernstein Advisors show that crypto prices are increasingly closely correlated to the ebb and flow of financial liquidity; when money is easy and credit abundant, speculative fervour rises. When conditions tighten, bubbles deflate. Bitcoin’s latest stumble might therefore be a sign that financial conditions are starting to tighten.
If you want to know where markets will go, watch liquidity
That brings the story back to its central theme since the pandemic: liquidity. Over the last five years, asset prices have been pushed higher by a combination of cheap money, government largesse and retail exuberance. Each time liquidity started to ebb the Federal Reserve obliged with easier policy or dovish hints. The central bank’s shift in tone at Jackson Hole this year was a case in point.
But with inflation still above target, and growth showing little material signs of cooling, policymakers will be reluctant to loosen too quickly. The White House may be eager for rate cuts to soothe middle class voters, and to help the hordes of crypto investing Maga acolytes nursing recent losses, but this Fed will be wary of going down in history as another one that lets inflation return on its watch.
This caution matters. Valuations in US equities are high by historical standards. The price-to-earnings multiple of the S&P 500 remains well above its long-term average, while the gap between equity yields and bond yields has narrowed sharply. Equity investors are being rewarded with very little for taking a lot more market risk than holding bonds. In such an environment, even robust earnings growth may not suffice to justify lofty prices without a fresh injection of liquidity.
For the rest of the year markets will depend less on corporate fundamentals than on the availability of money and confidence. If inflation continues to cool and the Fed signals a sustained easing cycle into the new year, risk appetite could revive. If not, the air may continue to leak from the frothier corners of the market, from AI to crypto.
After years of cheap money and boundless optimism, a touch of realism would not be unwelcome. For all the talk of artificial intelligence and superintelligence, investors may rediscover an older truth: in the end, liquidity is still the most powerful force in markets. DM