US equities at historically extreme levels

Dear Friends,

We hope you’re having a good start to the summer. This has been an eventful quarter.

On May 22, Kevin Warsh was confirmed as Fed chair, succeeding Jerome Powell who will finish the remaining two years of his term as a Fed governor, retaining a vote on interest rate policy. Powell survived extraordinary political pressure, including a DOJ investigation, which many believed was without merit and an effort by the Trump administration to force a more compliant monetary regime. The DOJ’s attempts to prosecute Chair Powell and the administration’s attempt to dismiss Fed Governor Cook for cause were both unsuccessful. Both cases were based on flimsy pretexts and driven by personal animus. The transition of power to Chair Warsh stabilizes the institution, which has seen its independence and stature challenged in profound ways during the second Trump administration.

Chair Warsh’s first statements have signalled continuity, sprinkled with some changes. It has been made clear that communication from the Chair will be markedly different in the Warsh era. Chair Warsh has indicated he prefers concise official statements and a return to the rather opaque Federal Reserve communications of the Greenspan era. Thus far, the bond market has taken this in stride, relieved that the immediate threats to Fed independence appear to have faded.

The equity markets have remained in bull market territory over this quarter, with occasional volatility. The story of the quarter has been anticipation of three blockbuster AI related IPOs over the remainder of this year. The first has already occurred. SpaceX’s IPO valued the company over $1.5 Trillion and its current market price places its valuation at over $2 Trillion. This is remarkable for a company that has not yet turned a profit, and has annual revenue under $20 billion. The bulk of SpaceX’s current revenues come from satellite-related communication services and rocket launches. OpenAI and Anthropic are expected to offer shares to the public in the coming months and each is expected to debut at a $1 trillion+ valuation. Perhaps in anticipation of these offerings, we have seen some rotation in technology stocks with several of the larger Tech companies seeing some investors reallocate capital.

As the USA enters the 250th anniversary of the country’s founding, the nation is embroiled in a war in the Middle East . Strangely, you could have said this for most of the past 40 years, and you would not have been wrong. The war in Iran appears to be qualitatively different from past wars the US has engaged in within the region. In the past, the superiority of American arms was abundantly clear. In the new world of drones and relative parity among missile defense systems, this is no longer the case. For markets, the most critical question, yet to be answered, is when the supply chain disruptions in the Persian Gulf will be over. Though there have been small reprieves, the Strait of Hormuz is still largely closed to commercial shipping that is not affiliated with Iran.

The disruption of oil supplies has had a limited effect on prices thus far, but this is entirely due to large scale releases from the strategic petroleum reserves of the US and other countries. These reserves are finite and the US’ Strategic Petroleum Reserve is now at its lowest level in over 40 years. The daily withdrawals from the reserve are north of a million barrels per day. At this rate, the ability to withdraw from the reserve will be severely limited in a few months. If that were to happen, we can expect oil prices to rise and inflationary pressure to drive prices for many goods and services up.

This is where the impact of the Federal Reserve will be felt most keenly. The new Fed chair will have one vote among twelve to set interest rate policy for the US Central Bank. Though most business media discussion focuses on the Consumer Price Index, the Fed evaluates a slightly different measure, PCE (Personal Consumption Expenditure). PCE year over year stands at 4.1%, as of May 2026. This is broadly in line with CPI figures, which are 4.2% annualized for May 2026. Much of the inflationary effect is due to fuel prices, which have seen a 20% rise, much of it ascribed to the war with Iran. The average consumer has seen electricity prices rise almost 6% over the past year, some of this is due to increased consumption by datacenters related to AI.

Bond markets now expect one, perhaps two rate hikes later this year, which would put the Treasury’s short-term interest rates at over 4% and long-term rates over 5%. At those levels, we can expect the dual impacts of investor rotation and debt servicing to apply downward pressure on prices and earnings in the equity markets respectively. In prior equity bull market cycles, it was interest rate rises that led to bear markets. In prior cycles, technology stocks would have been considered largely immune to interest rates since so few carried significant debt loads. The AI investment cycle has seen many tech firms raise tens of billions via debt. Though this has been raised at fixed yields, it makes many major technology companies look like more traditional industries where the cost of debt service impacts earnings.

Equity market valuations remain historically extreme. Trailing 12 month P/E is over 32, which is twice the long term mean of 16. Cyclically adjusted P/E is over 41, which is also twice the long-term mean of 17. The ‘Buffett Ratio’, Stocks as a percentage of GDP, is over 200 for the US, higher than it has ever been Valuations can remain above average for extended periods of time, that is what it means to be in a bull market. Such elevated valuations indicate that future returns for equity investors are likely to be muted unless growth too exceeds past history. The market currently seems to believe that will be the case, largely due to the advances made in Generative AI. However, we’re reminded of the dot com bubble when technology investors were also confident the emerging internet economy would transform the economy and usher in a golden age for technology stocks. While the economy was indeed transformed, during that cycle, the Nasdaq reached its peak in March of 2000 and didn’t eclipse that high water mark until April of 2015. Historically speaking, the highest levels of stock market volatility have come in the months of September/October.

We continue to recommend balanced allocations, with a bias towards caution with regards to equity portfolios. If technology stocks correct from their current loft highs, we expect to see investors diversify into defensive sectors, which look relatively undervalued. With the prospect of inflation coupled with rising bond yields, we recommend shorter than normal duration in bond portfolios, exposure to floating rate and inflation protected bonds as well as commodities.

If you would like to discuss any of these comments, please reach out to us via email.

Regards,

Louis Berger

Subir Grewal, CFA, CFP