The other side of the wall

Over the past several memos, we have been countering the widely cited concerns of Bears as being “bricks in the wall of worry,” i.e., often idiosyncratic issues that dominate the headlines but are not likely to derail US market fundamentals. We still hold that view, whether the concerns are private credit funds’ liquidity issues, the disruptive effects of AI on software companies, or the after effects of the slowly resolving Iran conflict (see Back to those other bricks). Almost on cue, even as the Bears have been clutching their worry beads, the market has begun to look through the near-term concerns to push to new highs. Yet, while the returns off the lows are eye catching, the year-to-date gains are less than 5% on the S&P 500 Index, though higher in some of the areas we have favored, such as small caps (12%) and value stocks (8%). Now seems an opportune time to remind our readers of just why we remain bullish and summarize the pillars of our year-end 2027 S&P target of 8,200.

1. Earnings are powering ahead. Secular bull markets are ultimately underwritten by earnings power and durable growth in cash flows. This remains the core driver of the powerful thrust higher that the US market has enjoyed since the 2022 lows. It also explains why investors continue to view sell-offs as buying opportunities. With nearly a quarter of the index reporting, the S&P is having a stellar first quarter earnings season. Every sector is beating expectations, on average, with overall index earnings surpassing forecasts by 10%. Furthermore, full-year estimates have risen from $310 at the start of the year to $328 today, with the majority of the advance coming since the start of the Iran war. Assuming we hit that number, S&P earnings will have risen by approximately 65% in the last five years, against a market rise of “only” 50%! A stark reminder that earnings have done most of the heavy lifting.
2. Valuations, though not cheap, are at least fair. Unlike the Bears, we are careful to distinguish between price performance and valuation risk. For instance, the S&P is up roughly 50% over the 4-plus years since the end of 2021, a compounded annual return of nearly 10%. But, again, this move has been “paid for” with earnings growth exceeding 65% over the same period. And while the 26% return off the recent lows of the tech sector is stunning, the sector’s return over the past six months of 5% seems more mundane given the 34% earnings growth experienced over that same six-month period. Their valuations have declined, not risen. Even the Mag 7 names, which have historically supported higher-than-market valuations, have seen meaningful valuation compression since mid-2023, with multiples declining from 34x to 29x today. While the forward multiples on the market and the Mag 7 are elevated versus long-term historical medians, at 21x and 29x respectively, they are roughly in line with levels that we think represent fair market value given above-trend earnings growth and record margins. And that is even after cutting our fair value assumption for the market to 20x to account for the concerns we and others have about the risks to pure asset-light business models going forward, along with worries about the longer term payoff of AI investments (see Still a Wall of Worry, not a brick wall).
3. The macro environment looks solid and likely to reaccelerate in the back half of the year. Despite all the “end of the world” concerns expressed around the Iran conflict, the incoming macro data remains constructive. The labor market has quietly improved versus last year, which we highlighted as a potential upside risk to start the year. After averaging a gain of roughly 9,000 jobs per month in 2025, nonfarm payroll growth has averaged 68,000 per month through the first quarter. This has helped support consumer demand as evidenced by last week’s retail sales data, which had the strongest month-over-month gain in a year across multiple categories. This performance has been reinforced by contemporaneous data series, such as travel demand and credit card spending. (P.S., we, like others, have begun to ignore the more bearish consumer confidence surveys, which are better barometers of political sentiment than consumer spending.) In addition to a strong labor market, consumers are boosted by the tax benefits from the One Big Beautiful Bill, real wage growth and record high wealth levels. On the inflation front, the picture also remains positive. Core index readings continue to surprise to the downside, driven by easing shelter inflation, despite the recent spike in energy prices. On the enterprise side, business investment remains a tailwind, as the early stages of the large-scale data-center and AI infrastructure buildout continue to power a $600 billion increase in capital expenditures (capex). Taken together — labor stabilization, real wage gains, policy-related tax benefits and a still robust capex cycle — conditions look consistent with continued expansion and the potential for improved growth momentum into the second half.
4. The Federal Reserve is likely to resume its rate cutting cycle by mid to late summer. With the Iran conflict pushing up oil prices, the Fed has hesitated to continue cutting rates. Overlay this with the Chair Powell Fed’s fixation with trailing data, and the late April rate cut that we and others once expected has long since been taken off the table. But with a more forward-looking Chair in Kevin Warsh on the way, and core inflation likely to resume its decline in the back half of the year, a renewed rate cutting cycle seems likely. It could begin at the September policy meeting. In a “goldilocks labor market,” i.e., steady employment growth without material wage acceleration, and with AI and automation expanding labor supply, we view the risk of a sustained acceleration in wage and service inflation as unlikely. Instead, core inflation readings are hovering around 2.5%, with the all-important owners' equivalent rent figures grinding ever lower. Instead, core inflation readings are hovering just above 2.5%, with the all-important owners' equivalent rent figures grinding ever lower. As this trend continues with Warsh in command, we expect the Fed to pursue a glide path toward a neutral policy rate of 3.0% compared to 3.75% today, assuming that the Iran conflict ends soon and oil comes near our $75 target. This would be just one more log on the fire.
5. The productivity enhancing effects of the AI revolution are upon us. Evidence continues to build that AI is already lifting productivity, particularly in industries with higher adoption. Importantly, the improvement appears to be driven more by faster output growth than by broad-based labor displacement. That’s consistent with AI functioning as a labor augmenting, capital-deepening technology rather than a job-destroying one. While the impacts are most visible in AI intensive sectors (software, data processing, computer systems design and computer manufacturing), they extend to industries like financial services, professional services, legal, education, and health care. Moreover, productivity growth has strengthened across all industry cohorts relative to the pre-pandemic decade, suggesting AI is reinforcing a broader efficiency drive, rather than acting in isolation. At the same time, we are optimistic about the scale of hyperscaler investment. As our colleague Phil Orlando recently pointed out, recent productivity releases have been averaging 3.7% per quarter compared to a much lower 1.9% during the Covid era. Investments in data centers and AI infrastructure should ultimately translate into meaningful operating leverage. Even with elevated capital expenditures over the next several years, we expect a more pronounced recovery in free cash flow, as utilization rises and monetization broadens. The combination of higher productivity and improving cash flow generation supports a broadening market advance.

Taken together, the market setup outlined here almost seems too good to be true. It may well be so. Certainly given the size and speed of the recovery off the recent lows, some kind of a consolidation would be entirely normal. That said, recent gains have not been accompanied by the kind of euphoric positioning that typically marks late-cycle tops. To the extent that investors de-risked during the Iran conflict, we expect they have yet to deploy the cash they raised at the lows back into the market. Therefore, we expect them to deploy on pullbacks, which would be fuel for a continued move higher. We are sticking with our substantial equity overweight and our call for the broad rally to continue. There are risks for sure, but on balance, they seem tilted to the upside. The other side of that Wall of Worry looks pretty bright to us.

Read more about our views and positioning at Capital Markets.