Highlights

• AI euphoria dispels market concerns

The volatility seen in the first quarter faded completely into the background in the second quarter, thanks to a massive, AI-driven tech rally.

• Vulnerability in the cycle

Although earnings expectations and profit margins are reaching record highs, we are currently in the middle of the economic cycle. This leaves the market extremely vulnerable to an inevitable growth slowdown.

• Increasing Market Risks

Both market valuations and margin debt are approaching historical peaks, which clearly points to a deteriorating risk-reward profile for equities.

• Resolute capital protection

We remain committed to our value discipline. Thanks to the successful sale of technology shares (Nokia and Infineon) that were overvalued at the time of sale, the portfolio has a relatively high cash position.

From Q1 Concerns to Q2 AI Euphoria

Writing just three months ago at the end of Q1, investor angst was focussed on two issues – 1) The negative global supply shock caused by the closure of the Strait of Hormuz, and 2) The growing stress in private credit markets as investor redemptions continued to exceed the capacity of many funds to honour their obligations.

Writing today, it hardly seems necessary to mention either of these concerns despite the reality that neither have been truly resolved. In Q1, the US equity market posted its weakest quarter for four years, but this was more than recovered in Q2 driven by a revival in the AI trade. Technology shares returned over +30% on average during the period, posting the sector’s strongest performance in over two decades led by outsized gains in semiconductor-related industries.

Investors appear to put no limits on the future of AI spending. Demand is outweighing supply, hyperscaler CEOs still fear being left behind, and the capital markets remain wide open for almost any amount of debt or equity required. Investor comfort seems to rest on the exceptional US-led earnings growth. Both 2026 and 2027 earnings expectations continue to rise (chart below) with earnings growth projected at around +24% for this year and + 17% for 2027. In the context of well-behaved bond yields, and spreads for corporate borrowers remaining at historically low levels, market bulls can argue that the still-supportive fundamentals point to a maturing but not yet exhausted market uptrend.

Source: Strategas Research Partners

The context of these exceptional earnings expectations seems to be mostly overlooked which is not unusual as investor optimism becomes entrenched. Historically, this magnitude of earnings growth has been associated with the early stages of an economic expansion when earnings are recovering from a low base. These projections are occurring in the middle of an economic cycle with profitability measures at an all-time peak.

The chart below shows the trend in US corporate profitability during the last fifteen years – an almost uninterrupted upward trend. There are some merits to the argument that the composition of the market has changed as it has moved from an asset-heavy industrial base to a more asset-light technology and consumer brand base. This argument is starting to crumble under the pressure of the five largest hyperscalers projected to spend over $1 trillion on AI capex in the next twelve months - no longer funded by free cash flow but now by debt and new equity financing. The question that we cannot ignore as prudent investors with a focus on protecting capital is whether this is as good as it gets. Earnings estimates are approaching levels where a lot of good news has already been priced in, leaving the market vulnerable when the inevitable slowdown materialises.

Source: Strategas Research Partners

A stretched earnings environment could be cushioned somewhat from undemanding market valuations. Unfortunately, as the chart below shows for the S&P 500, valuation multiples remain stubbornly close to levels that have historically been associated with sizeable market corrections.

Peak earnings and peak valuations do not provide the ideal backdrop for a sustainable market advance. High valuations tend not to be a problem when earnings growth is strong, but it does become a problem very quickly when earnings growth inevitable slows.

Source: Strategas Research Partners

Investors are going ‘all-in’ at the market peak

Making matters even worse, this combination of stretched earnings and valuations has been accompanied by record or near-record high levels of margin debt (charts below), whether measured relative to US market cap or broad-based measures of money supply (M2).

The resilient march upwards of most risk assets has imbued investors with a high level of confidence as to the prospect for future returns. Essentially the investor is “all-in” at a time when the risk-reward profile of equites has significantly deteriorated.

Source: Strategas Research Partners

Maintaining value discipline and capital protection

Throughout this rising AI euphoria we have stuck with our value discipline. The result is that our portfolios have lagged on a relative basis in Q2 and we did finish the quarter with our highest allocation to cash for the year.

This cash position is the result of our sales of two equity holdings during the period – Nokia and Infineon.

Both companies have got caught up in the AI theme with the result that their stock price rise has far exceeded any meaningful change in their earnings trajectory. At their peak price in Q2 Nokia had recorded a +165% gain for the year and Infineon had posted a +130% return.

We do not see ourselves as competing with index funds, the market, or the neighbours. Our repeated primary goal is to avoid any permanent loss of client capital. We judge this goal best realised by following the advice of Buffett:

"Be fearful when others are greedy, and greedy when others are fearful."

When we survey the investor landscape we struggle to find any meaningful pockets of investor fear. On the contrary. The response of Elon Musk on social media to an investor who questioned the +$2 trillion valuation of Space X on its IPO is clearly not his alone – “You don't seem to understand that SpaceX will be worth more than the rest of Earth if we accomplish our goals .”

When investors are incorporating heavenly profits into their valuations, we do think it prudent to sharpen our focus even more and continue to be patient, process driven, ensuring that each investment contains a sufficient margin of safety, and not assuming that the sun will shine 365 days a year in our forecasts.

We remain confident in the absolute return potential of our portfolio for the remainder of 2026.