The Market's Biggest Puzzle: Why Stocks Keep Rising as Rates Surge

Kristian Kerr [0:13] Welcome to Market Signals. I'm Kristian Kerr, head of Macro and Investment Strategy at LPL, and I'll be your host this week. Well, it's been a busy and eventful stretch for markets since Labor Day. On the surface, investors continue to grapple with many of the same forces that have been driving markets for much of the year, rising energy prices, elevated bond yields, and ongoing geopolitical tensions. And of late, the more economically sensitive and rate dependent areas of the market like small caps have certainly struggled to keep pace.

But beneath the surface, a different story seems to be unfolding. Some of the market's most important secular growth themes are beginning to reassert themselves. The Mag Seven and NASDAQ-100, for instance, have recently pushed new all-time highs as investors increasingly focus on the next phase of AI adoption. The result is a market being pulled in several different directions all at once, and with so many competing narratives and cross-currents separating signal from noise has become increasingly challenging.

Kristian Kerr [1:04] So to help us break it all down, today we're joined by LPL's own chief equity strategist, Jeffrey Buchbinder. Jeff, how are you doing? Thanks for joining us today.

Jeffrey Buchbinder [1:13] Doing well, thanks, Kristian. Good to be with you, and nice to be on this side of the table. Yeah. Used to be on the other side.

Kristian Kerr [1:19] It's a nice role reversal here. All right, Jeff, let's just dive right in. You know, stocks are sitting there all-time highs, even as Treasury yields have pushed their highest level since before the financial crisis. Why do you think the equity market's able to stay so resilient, in the face of sharply high rates? You know, is the equity market sending a different message in the bond market here?

Jeffrey Buchbinder [1:44] Yeah, I think it's a simple answer, Kristian. It's the strong economic growth, which is, of course, related to the earnings boom. That is AI-driven, of course, primarily.

I would say that's probably the majority of what's keeping this market well supported, but I think there's also prospects for lower oil prices after we get some sort of resolution in the Middle East. That might take until after the midterms, but that is, I would say, keeping this market afloat, even in the face of high oil and rising interest rates. Yeah.

Kristian Kerr [2:20] I think that's fair. You know, we've gotten what, you know, a lot of people want to compare this, like, 2022 where we had the Fed hiking rates. And what I tell people there is, it's kind of along the same lines you're saying, Jeff, that, you know, during that period, we had negative earnings revisions, right? I think to around, you know, mid-single digits.

And this time around this year, even though rates are rising, we are, you know, we're what, like, 15% earnings revisions is on the year or something like that, right? So that's a very different profile or picture for markets. And I think that at least explains a big part of the reason why, you know, we're seeing equities look past this. But, you know, we are at kind of interesting levels here in the 10-year.

Kristian Kerr [3:03] So, you know, what do you think would happen? I mean, can we stay immune to what's going on in rates? I mean, we start to move towards, like, 6%, or something like that in 10-year yields. You think the market could continue to look past this or does it start, are there certain levels of yields that really start to impact, and flow through into the equity market? And if so, what areas of the market do you think would be the most vulnerable here?

Jeffrey Buchbinder [3:30] Yeah. If you go back and look at the relationship between the stock market and interest rates, you actually see that it's not so much around a specific level, as it is about how fast rates move. So, now, of course, the 1980s were a different animal. We're not talking about interest rates near 20% here. But people may be surprised to learn that in the late '90s, the 10-year yield averaged around 5.9%. And of course, as we know, largely due to the build out of the internet, the stock market did just fine.

So, in that regard, this is a similar environment where you've got a tech revolution, strong earnings, strong economic growth, offsetting the fears of interest rates. The other difference, though, between now and the 90s is we have a lot more debt right now.

Jeffrey Buchbinder [4:30] And so, that certainly makes this economy and market maybe a little bit more sensitive to the level. But, for now, as long as rates are steady, we think that stocks can hang in there. Yeah.

Kristian Kerr [4:43] That's a good point. And there's nothing magical per se about 5% other than maybe, you know, Bessent had talked about that level, but yeah, you know, very much agree with you. It's more about a rate of change dynamic than any single, you know, particular number out there.

All right. So the other kind of big news driving markets that we touched upon at the intro, was this announcement of Meta's Muse, and the emergence of so-called, you know, AGI, some likening this launch of Meta's Muse to ChatGPT. You know, are we entering a new phase of the AI investment cycle, you know, with the conversation shifting towards AI agents, applications, productivity tools, where do you think we are in the AI adoption curve and which layer of the ecosystem offers the most compelling opportunities here from your lens?

Jeffrey Buchbinder [5:36] Yeah, I would actually argue that we entered a new phase during the Q2 earnings season when we heard about accelerating cloud revenue, right? A lot of skepticism about AI monetization heading into Q2, and these companies, you know, not only continue to raise their forecasts for capital investment building out data centers, but they saw accelerating cloud revenue. So it's not over yet. This is not a time where these hyperscalers should declare victory and say, "See, we can monetize this." But it was a positive step and signal to at least me, I think, in the markets that maybe we've moved into this monetization phase.

In terms of opportunities, I mean, there's a lot of runway to go here, first of all, based on surveys from Ramp, there's only about two-thirds of large businesses that have actually adopted AI.

Jeffrey Buchbinder [6:31] Everybody's, of course, looking at it, but to consider themselves adopters, we have a ways to go. So we're still in this infrastructure build out phase. The biggest opportunity it seems for these LLMs, the large language models, appears to be corporate. That is, of course, where most of the dollars are. You need to do more than just save consumers time. That is helpful, but that is not how this is really going to be monetized. It's going to be more about business productivity and we're not going to know just how well that will play out for at least another year or two and possibly even longer.

Kristian Kerr [7:17] Yeah, I can certainly buy into that. I mean, I guess as a follow-up, Jeff, you know, do you think the emergence of AGI, does that broaden the opportunity set for investors or does it simply just make, you know, the biggest platforms that much more dominant, right? Kind of more of a bigger picture question, but just to get your thoughts on that.

Jeffrey Buchbinder [7:41] Yeah, we're certainly not the point where these models are commodities, but with the competition from the open source providers, Chinese models, eventually, this is just going to be a commodity, right? We've got to build out a lot of compute to get to that point, but that means that this opportunity will broaden out because everybody's going to have access, right? Tokens will be cheap.

So there's absolutely a massive productivity carrot at the end of this, and most likely it's going to justify a lot of this spending. There will be wasteful spending, no doubt, but a lot of this spending, I would argue, is going to be justified, and that means that a lot of companies, broad companies, across many industries, are going to benefit. But again, the infrastructure spending is still ramping up though. We're probably not going to peak for at least a couple of years.

Jeffrey Buchbinder [8:43] So the tough part for investors is trying to value the other side of the peak in spending, and that's going to, that debate's going to continue for probably the next couple of years, and that's where you're going to get these rotations toward the hyperscalers, away from the hyperscalers, toward the defensives, toward the chip makers, right? I would just argue it's going to be back and forth and back and forth, and you're not going to have one clear winner emerge for some time.

Kristian Kerr [9:15] Okay. Yes, that's a great segue into another area I kind of wanted to get into today, which is the breadth, I guess, the lack of breadth in the market. I mean, as of last week, you know, the median stock in the S&P 500 is off over 15% from its 52-week high, as relatively few names continue to hold the broader indexes up. I think I know the answer, but how do you interpret this recent bout of poor breadth in the market, and how do you think it plays out here?

Jeffrey Buchbinder [9:49] Well, I'd first say that it makes sense, because really, AI is the only game in town, right? So, in fact, as a percentage of GDP, the AI CapEx for the cycle is potentially going to be 3%, right? If this economy grows 3% over the next few years, I think most investors would take that. That could generally be all from AI. And certainly, you saw during Q2 earnings season, and we're going to see it again in Q3 earnings season, that the AI-driven areas of the market are producing the best earnings.

So given that I'm an old, you know, kind of old school fundamentalist, earnings drive stock prices, the market should be favoring the areas that are seeing the strongest earnings growth and that are benefiting from that CapEx build out. So there are a lot of different areas you can play in the AI supply chain, but that's still probably the best place to be, and then we'll just have to wait and see how much these other industries are able to benefit from the productivity gains in coming quarters and years.

Kristian Kerr [11:03] Okay. And how about in the near term, right? Does this lack of breadth, does that ultimately kind of in the near term lead to a catch-up by the rest of the market, to, you know, the Mag Seven, the S&P 10, or do you think we just kind of see those names continue to kind of lead us higher into Q4 and beyond?

Jeffrey Buchbinder [11:28] Yeah, well, we've already seen corrective phases for the hyperscalers and the AI infrastructure plays at various times, right? Look no further than the massive correction in the Korean memory names. That was probably the most extreme example. It hasn't been a great year for the hyperscalers as a group, and the valuations are not really that demanding. So generally speaking, probably look for that area of the market to lead us in Q4. We're heading into a really strong seasonal period, but you'll have back and forth. There could be a time where you see yields drop, if oil comes down, and then you might see some of the more interest rate sensitive areas of the market play catch up, right? We've seen this relationship between energy and consumer discretionary where if oil's up, energy works and CD does not, and vice versa.

Jeffrey Buchbinder [12:31] So that's something that we could see in terms of a rotation. You could also see semis and software jostle back and forth for leadership. Some of the AI names that have been considered disruption or disrupted, potentially could bounce back. There's certainly been a lot of debate in the market. There has been a bounce back in some of the software names, the SaaS apocalypse, right?

So we would be looking for opportunities there, potentially. So sure, there are opportunities, but we would argue that most of the opportunities are probably going to be related to the AI complex, over the course of the rest of the year.

Kristian Kerr [13:13] Okay. Yeah, great stuff. Yeah, let's just to wrap things up here, you know, you kind of alluded to it, you know, Q3 about to end. What are you looking for into year-end? You know, what are some of the biggest market risks or opportunities, you think investors should be on the lookout for in the last three months of the year?

Jeffrey Buchbinder [13:39] Yeah, well, first, we got to watch the Middle East. A resolution there can go a long way toward bringing oil prices down and with them rates. But beyond that, I mean, I mentioned the seasonality. Q4 seasonality is really, really strong, and it's even stronger in midterm years. Q4 average gain is about 6% for the S&P, and you have positives about 85% of the time. So our advice to folks out there listening would be to not get too defensive here heading into Q4.

In fact, literally today, as we're recording this, September 29th, I think this is the seasonal bottom based on the last couple of decades. So don't get too defensive, don't get too cautious here, because good chance that stocks go higher over the course of the year. The Middle East is probably the biggest risk, but certainly, over time, you've seen the midterm elections be a pretty big risk.

Jeffrey Buchbinder [14:42] So we got to watch for that. You could get a surprise. Not a prediction, but you certainly could get a surprise coming out of Washington.

Kristian Kerr [14:53] Right. I think we can wrap things up there, Jeff. Thank you so much. Great, great insights, as always. Thank you as well to our listeners for joining. We appreciate you spending part of your week with us, and we hope you found today's discussion helpful. Please be sure to join us next week, for another edition of Market Signals. Until then, take care. Have a great week, and bye for now.