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Price Stability

Fed Head Ben Bernanke established a 2% inflation target for the Federal Funds rate in 2012. Prior to that, the Fed didn’t have a numerical inflation bogey. Post that decision, markets calibrated economic and interest rate expectations around the 2% objective. Unfortunately, inflation bedevils the Fed by continuously undershooting and overshooting the 2%:

Pre-Covid stimulus spray, inflation held stubbornly below 2%, inspiring Fed Head Powell to loosen the target to an “average” of 2% in August of 2020. Since then, inflation has averaged 3.6%. After some encouraging disinflation in early 2025, the combination of the AI buildout boom, immigration controls, tariff impositions, and oil blockades has pressured inflation higher. When adding back food and energy, excluded from the Fed’s preferred measure due to volatility, the inflation story worsens:

For the year ending in May, overall US consumer price inflation rose 4.2%. Therefore, while the Fed may have a 3.3% policy inflation problem, they have a 4.2% headline inflation problem, making a solid case for the Fed to raise rates, not lower them.

For Warsh to argue for lower rates, he must identify more durable disinflationary forces within the data. Housing inflation trends add some assistance and represent 18% of the Fed’s preferred inflation measure, deserving reference:

Warsh has also spoken to the disinflationary impact of AI productivity gains across the economy. While we support this observation, the economy must build the AI before benefitting from the AI, which implies shortage driven inflation in the near term (commodities, tech hardware, utility capacity, etc.) in exchange for productivity disinflation in the longer term. If the Fed overreacts to the near-term inflation, it could forestall more durable longer-term economic benefits by restraining AI Capex. For now, the productivity argument appears real and intact:

Ignore recession driven productivity gains as distorted data. The last true productivity surge occurred during the late 1990’s. During this period (1995-2000) core inflation averaged 1.7% and fell as productivity rose. There is certainly modern historical precedent for Warsh’s productivity argument. I would expect him to harp on this next Wednesday.

Lastly, Warsh may site the “transitory” nature of current inflation. 60% of the inflationary gain last month can be attributed to war stoked energy inflation, any war relief should provide inflation relief. Also, AI Capex may cool at the margin as companies reconcile spending with returns, rationalizing shortages. Lastly, inflationary base effects may provide optical relief as June, July, and August 2025 ran hot and those numbers will fall away with each upcoming release. Taken together, longer term inflation expectations appear well within normal ranges, having actually fallen recently:

Maximum Employment

As we have long argued, gains in productivity do not mean fewer jobs and lower wages as frequently feared, but more jobs and higher wages as frequently proven. Nothing punctuates this point better than the comparison of job opening data for software developers versus the economy at large:

Furthermore, the AI jobs apocalypse remains overdue as the US economy has blown away hiring expectations so far this year:

Overall, the US unemployment rate sits at 4.3%, well within the Fed’s range of “maximum employment.” Additionally, the unemployment rate for the youth cohort most “AI at risk” registers at 7.2%, which seems high until you compare that rate to itself over time:

So, the good news is that jobs seem plentiful for all… even the youth and software developers. Therefore, the Fed has met its maximum employment mandate. The bad news is that tight labor markets can often metastasize into inflation up-force. Fortunately, despite employment gains, overall employment inflation, while still elevated from COVID levels, appears largely contained:

The employment cost index rate of 3.3% is the lowest year-over-year growth rate since 2021. For the Fed, a 3.5% employment cost index minus a 2.5% productivity growth rate leaves a unit labor cost inflation rate of 1%. Historically, this is unusual as labor inflation rates often exceed headline inflation rates. That is not the case currently and helps support Fed Head Warsh’s dovish stance despite tight labor markets.

While SpaceX made the story of the week, the fireworks over Warsh’s first official press conference interests us more, and will matter more to longer term investors, overall. Popcorn popping!

Have a great Sunday!

-David

Sources: Federal Reserve Bank of St. Louis, Yardeni Research

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

In the mid-1990’s, IT investment grew between 10-12% annually, reaching a peak to offset the Y2K threat at 17%. Following COVID and the inception of the virtual office economy, IT investment grew 10-12%. Today, IT investment is growing by nearly 20%, well above any rate seen over the period. Moreso, that growth rate comes on top of an already sizable base. When adjusting the chart above for dollar change rather than percentage change, the investment scale becomes even more notable:

And because of the historic magnitude of this investment cycle, the influence and economic stimulus of IT investment within the US economy continues to grow in magnitude as well:

IT investment now accounts for 5% of the entire US economy. In other words, the US is allocating $1 out of every $20 the economy produces to IT investment. In addition to becoming such a large allocation, IT investment has become the largest contributor to US GDP growth, contributing 67% of Q1 GDP growth, far beyond anything seen before. And because the investment boom is largely hardware related, it trickles down the entire supply chain from high tech fliers to infrastructure and power suppliers. Consider the sheer amount of electricity demand being created by the AI revolution:

All this hardware, construction, and power demand creates supply shortages and price pressures across various commodities:

This brings us to corporate earnings, which surged in the first quarter to levels seldom seen outside of post recessionary turns:

Excited yet? The combination of insatiable demand for compute, deep pools of earnings and capital to finance CAPEX, and shortages across the economy have unlocked generational levels of corporate profits and investor returns. Lastly, given the “structural” nature of the AI Revolution rather than the “cyclical” nature of typical technology cycles, valuations for more cyclically oriented companies like Micron and SanDisk should rise to levels of less cyclical companies like Microsoft and Apple. This perspective calls not for a rally in these cyclical players but a complete repricing given their transformation from episodic businesses into stalwart annuity businesses!

Furthermore, analysts have mapped the “structural not cyclical” earnings benefits across the entire US market complex.

Of all the charts presented, this is perhaps the most profound. According to analysts, over the next 5 years (the blue line) US public companies will experience earnings growth of nearly 23% annually. This requires an historic combination of revenue growth and profit margin growth to get there. Corporate revenues, or sales, largely track nominal GDP growth (growth + inflation since revenues are quoted gross of inflation). In Q1, US nominal GDP grew a spirited 5.9%, towards the top end of its recent range:

To accommodate the revenue growth required over the next five years, nominal GDP would have to rise substantially back to levels we haven’t seen since the 1970s. Absent that level of nominal GDP growth, profit margins would have to expand substantially, which has been occurring in tech land but not as obviously in non-tech land:

For profit margins to surge enough from here to overcome nominal GDP and revenue constraints, non-tech participants will need to double their operating efficiencies to meet these wildly ambitious forward earnings forecasts. Possible perhaps, but not probable. Lastly, corporations could source additional earnings power from “other income” and accounting adjustments. For instance, last quarter the circular financing within the hyper-scalers (swapping cloud capacity for Anthropic and Open AI stock), led to mark-to-market gains that accounted for perhaps a third of overall Q1 earnings growth:

As long as these trillion-dollar startups double their valuations each year over the next five years, “other income” accounting adjustments will contribute significantly. Consider the mark-to-market benefits for the Japanese Nikkei at the end of the 1980s! Absent this accounting alchemy, revenues and margin expansions will likely fall far short of analyst expectations and terms like “insatiable demand” and “unlimited pricing power” will once again become siren calls leading investors into the rocks. While that seems inevitable to us, the timing of comeuppance remains unknowable. Recall that Greenspan labeled the last episode of market exuberance “irrational” three years prior to its demise. While today’s AI Revolution may not be immune to cyclicality, it’s clearly a super cycle poised to run beyond rationality, if it hasn’t already. We will monitor the macro cues for what’s reasonable and watch the unreasonable, from afar.

Have a great weekend!

-David

Sources: Federal Reserve Bank of St. Louis, McKinsey & Company, Charlie Bilello & Creative Planning, Factset, Yardeni Research, Bank of America Research, Bianco Research, Andreessen Horowitz, Bespoke Investment Group

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Every driver can go fast, but the winners rely on optimizing car balance and race strategy to navigate the track. Low downforce and you’ll struggle in the turns. Poor tire strategy and you’ll lose speed. Investing is no different, and my sport correlations don’t end! Let’s explore.

Two-Legged Stool

For the last several weeks, investors have enjoyed fruitful returns fueled by robust corporate earnings data and increasing forward earnings estimates. A 2026 full year S&P 500 bottom-up earnings estimate of $334 and a 4.5% 10-year treasury yield nets a fair value for the S&P at 7,544. The index sits right near this mark as of Friday.

However, bond yields have continued their rise this year, with the 10-year Treasury reaching its highest level in more than a year. This has created downward pressure on bond total returns, which remain negative year-to-date in the U.S:

For decades, investors have relied on the classic “two-legged stool” of stocks and bonds. Stocks can provide growth, while bonds can offer income and downside protection. But recent market environments have exposed an important reality: sometimes both legs wobble at the same time.

In 2022, for example, both stocks and bonds declined together as rising interest rates pressured traditional asset classes simultaneously. Investors learned that bonds alone do not always provide protection when correlations rise. The chart below highlights how stocks and bonds have behaved more similarly in recent years:

That is where liquid alternatives can serve as the portfolio’s third engine.

Liquid alternative strategies are designed to generate returns that are less dependent on the direction of traditional markets. Instead of simply riding markets higher or lower, these strategies seek opportunities through different approaches and can have lower correlation to stocks and bonds. Think of liquid alternatives as the pit crew of a portfolio. They are not responsible for driving the car at top speeds, but when markets become volatile, correlations spike, or economic conditions suddenly change, they can provide critical balance and stability.

For a brief example, here is a chart of the same five-year correlation of returns comparing bonds, equity market neutral, and trend-following strategies relative to the S&P 500. The closer the number to 1, the more similar the assets behave. Notably, bonds have recently shown a higher correlation to stocks than these select alternative strategies.

Of course, diversification and risk management are the primary focus here, but investor returns matter as well. Importantly, liquid alternatives are not intended to replace stocks and bonds. Just as racecars require speed and durability, portfolios can benefit from growth and income-producing investments. Alternatives are designed to complement those core holdings by adding diversification from strategies that operate differently. The objective is not to eliminate risk but to build a more resilient portfolio capable of navigating changing market conditions.

Have a great week!

-Matt

Sources: FactSet, YCharts, AQR Capital Management

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Geography

Despite the headlines that Epic Fury has inflicted more pain on the offshore economies than our own, the investment returns read otherwise. While the US market (represented here by the S&P 500) has risen 8% year to date, the developed international markets (represented by the EAFE) have risen 9%, and the emerging markets (represented by the MSCI EM) have risen 23%. If we disaggregate further, even more surprises arise. For instance, the Israeli stock market (ETF: EIS) has climbed 24% this year, perhaps because wars ultimately have winners. International investors must also consider currency fluctuations. Typically, geopolitical frictions trigger capital flights to quality, boosting the USD. This happened in the initial phases of Epic Fury, but this has since reverted with the US Dollar down 0.5% on the year, adding a slight uptick to international return calculations.  In all, the Geographic returns remind us that headlines and bottom lines often do not correlate.

Investment Style

Investment bias essentially established two investment styles. Those who want to invest in what’s cheap today became known as “value” investors and those who want to invest in what will become bigger tomorrow became known as “growth” investors. Berkshire Hathaway is the largest holding in the value index above (ETF: IWD), while NVIDIA is the largest holding in the growth index above (ETF: IWF). Because the AI trade has become so dominant growth indices rely heavily on NVIDIA and the Magnificent 7 for direction. These stocks struggled early in the year as investors questioned the viability of the capex spending and the trajectory for their earnings. This created an advantage for the more “knowable” value style companies trading at lower P/E’s with lower earnings expectations thresholds to overcome. However, enthusiasm for growth has returned with the war winding down, rate cuts on approach, and stellar earnings results from the Magnificents. As clearly shown, there are no “right” investment styles, only oscillations between them.

Market Capitalization

In theory, smaller companies grow faster than larger companies due to scale advantages, which should support higher investment returns. While this has been true over a long period of time, it has not been true over the last mega tech decade. Over the past 10 years the S&P 500 large cap index (ETF: SPY) has returned 320% for investors while the Russell 2000 small cap index (ETF: IWM) returned 194%. That yawning divide has left many who believe in reversion to the mean to favor small over large more recently. Their bets have been rewarded as the smalls have gained 17% on the year versus 8% for the bigs. Will this continue?  Perhaps. The combination of economic acceleration and lower short-term interest rates should support the small co earnings complex, while valuation convergence continues. But should the macros deteriorate, it’s likely the smalls will as well. They historically trade as volatility enhancers which can be great on the upside… but less great on the downside.

Sectors

Sectors often make the best thematic tracing vehicles. Think the economy is going to accelerate? Consider owning those most cyclically oriented like energy, materials, and industrials. Think the economy will recess? Consider owning those most defensive like consumer staples, healthcare, and utilities. These tend to be reliable bets unless something peculiar occurs like regulatory changes for healthcare or AI Capex demands making utilities behave like growth stocks. On the year, the cluster of energy, technology, materials, and industrials in the lead suggests a broad-based economic advance. Consumer discretionary has lagged amidst concerns over energy spending displacement and financials lack an AI narrative and the promise of rate cuts.  From here, resolution in Iran will pressure energy lower, but other cyclicals higher. Financials look cheap with loan volumes rising and rates falling, perhaps poised for a move. Healthcare performance resembles the healthcare sector overall: sluggish and confusing.

Taken together, the complex shows some return variations but conformity with a theme.  The US economy isn’t recessing anytime soon, the capex cycle isn’t ending anytime soon, and this bull market isn’t ending anytime soon.

Have a great weekend and Happy Mother’s Day!

-David

Sources: YCharts, Morningstar

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Iran has recently increased its defiance. Trump has recently increased his threats. Onshore oil prices peaked this week roughly 10% below their wartime high while offshore oil prices peaked 10% above their wartime high. The longer the conflict lasts, the more depleted oil inventories become, and the more upward pressure exerts on price:

Oil traders have to balance supply restriction and demand destruction, with conflict resolution odds, to project prices into the future. Here are the changes across the Brent crude futures curve:

Brent futures price in more Middle East disruption given its seaborn nature. Here in the US, we quote West Texas Intermediate prices as we supply our own oil onshore, largely insulating us from the Middle East disruption. This has created a $10 per barrel savings for US citizens compared with the curve above. Nonetheless, across the curve, prices have shifted higher, accounting for falling confidence in swift war resolution. In sum, probability has risen that oil prices will be higher for longer as negotiation impasses persist, increasing stagflation risks and stock market vulnerabilities.

Capex Pace?

Five of the Magnificent 7 (Apple, Amazon, Google, Meta, Microsoft, Nvidia, Tesla) reported earnings this week. Each reported better earnings than analysts expected, as usual. More importantly, the cohort raised their AI capital expenditures estimates for 2026 from roughly $650 billion to $725 billion. Note not only the scale, but also the significant acceleration this year:

To help size the magnitude of this investment, consider that the US Economy grew 2% in the first quarter of 2026 and capital expenditures accounted for 70% of that growth rate. This rising tide lifts all boats seen in the earnings surge for non-tech companies that supply tech companies with copper, cables, concrete, etc. In fact, the highest sector level returns this year do not belong to technology (who will win?), but to energy, materials and industrials (everyone wins!). While Mag-7 earnings have fueled the market advance over the last couple of years, the Non-Mags have begun catching up. Stripping Nvidia from the calculation, Non-Mags earning growth will likely outpace the Mag-7 earnings growth rate for 2026:

This AI Capex driven earnings cornucopia doesn’t only exist within the S&P 500 Large Cap universe, but also within the S&P 400 Mid Cap and S&P 600 Small Cap universes as well:

Frankly, I am not sure I recall a time with this much earnings power present so ubiquitously. The risk arises when considering how much financial capacity the Mag-7 have for spending at this level. Fortunately, they run very high profit margins and generate significant cash flow allowing them to largely self-finance (source: Bespoke):

Meaning, while Capex spending levels may seem atmospheric, they have yet to peak. In sum, probabilities have risen that AI capital expenditures will be higher for longer as the AI arms race persists, increasing economic, earnings and investor prospects.

So, which matters more to markets, oil prices or capex pace? With markets closing the month out at all-time highs, it seems resolved that the AI Capex cycle being higher for longer matters more than oil prices being higher for longer.

Bonus Data Point: US Households spend $650 billion directly and indirectly on oil annually; roughly $100 billion less than the Magnificent 7 will spend on AI capex in 2026.

Have a great weekend!

-David

Sources: JP Morgan, Emre Akcakmak (East Capital Group), Statista.com, Yardeni Research, Bespoke, FactSet Earnings Insight

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Corporate Earnings

At the beginning of 2026, analysts expected around 15% annual earnings growth for the S&P 500 (the green line). Since then, analysts have marked up their earnings estimates to over 18%. Compare this with the 8.8% median growth rate over the last 20 years. Analysts also expect constituent revenues to increase nearly 10% this year while profit margins expand. Higher revenues, higher profit margins, higher earnings. Hat Trick! Seem unreasonable? So far, 9% of the S&P 500 companies have reported their first-quarter earnings. 90% have beaten expectations. Analysts have raised their revenue and earnings targets considerably since the war began. Should these assumptions prove correct, the S&P 500 will generate $323 in earnings this year. How much should investors pay for them?

Fair Value

In finance, what investors willingly pay for earnings is known as “the multiple”. If a company earns $100 and you are willing to pay $1,000 for it, the company has a 10x multiple. If it’s a great company with higher-than-average prospects, perhaps you will pay 20x. As in real estate, all individual company valuation decisions are local. At the market level, prevailing interest rates largely determine multiples. To arrive at a fair-value multiple, simply invert them. For instance, a 10% interest rate environment supports a 10x multiple, while a 5% interest rate environment supports a 20x multiple. Today, the 10-year Treasury bond yields 4.25%, supporting a fair market multiple of 23.5x for the S&P 500. During the fog of war, the S&P 500 multiple fell to just over 19x, making the market meaningfully undervalued as seen above. Now, let’s do math! $323 in expected earnings multiplied by 23.5x produces a fair value estimate of 7,590. That’s 11% higher than last Friday’s close at 6,817, and that doesn’t even begin to consider 2027’s earnings estimate of $378.

Mathing Iran

Anytime the government increases spending without raising taxes, fiscal deficits increase. Economists call increased deficits economic “stimulus”. By many estimates the war in Iran increased deficit spending $1 billion a day. That’s stimulus. Conversely, higher oil prices tax the economy. Gasoline increased 35% per gallon due to production and transportation disruptions. On average, US households spend around $50 a week on gas. A 35% increase equates to an additional $15 a week. The war has lasted 6 weeks, costing the US consumer $90 extra dollars at the pump, so far. Fortunately, this tax season, IRS refunds increased 11%, generating an additional $350 for each filer, on average. This stimulus more than offsets the drag at the pump, making the consumer hit from $100 oil largely a non-event, leaving earnings expectations intact.

The Math

Concerns over wartime inflation drove interest rates up from 4% to 4.44% at their apex. This put mathematical downforce on fair value multiples from 25x to 22.5x, overshadowing the resilience of earnings. Certain stocks (tech stocks) with above-market multiples corrected most, while those more reasonably priced corrected least. However, overall valuations entered the period below fair value raising the risk of overshot and increasing the potential for rapid recovery. The multiple for the S&P 500 ended last year around 23x and bottomed recently at 19x. That’s a 17% discount! 

With war waning, increased earnings expectations combined with decreased valuations enable a double positive. Higher earnings times higher multiples powered these higher highs. It’s just math!

Have a great Sunday!

-David

Sources: Yardeni Research

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Markets work much the same way. The underlying course of investing—discipline, allocation, risk management, and patience—remains constant, but each year brings new conditions that challenge us as investors. Some years reward aggression, others punish it. Success comes not from assuming the course will play the same way it did in years prior, but from recognizing the conditions and adjusting accordingly.

This year, Augusta National is playing firm and fast. Shots that may have held in other years are bouncing forward. Approach shots require a more precise landing spot. A miss that might have left a manageable putt in softer years could now leave a nervy up-and-down. The margins are thinner, and the penalty for being out of position is more severe.

That feels like an appropriate analogy for the environment investors have faced so far this year. This has not been a calm, predictable year. Investors have digested war in the Middle East, uncertainty surrounding negotiations with Iran, large swings in oil prices, and a market pullback that felt worse than the numbers now suggest. Consider the below chart.

Nearly every year looks different. Some years bring modest setbacks, while others bring sharp drawdowns that test investor resolve. And yet, despite those pullbacks, most years still finish with positive calendar-year returns. In other words, the destination and the journey are often two very different things.

That has certainly been true so far this year. Investors have navigated war, fragile ceasefire negotiations, energy volatility, and a meaningful market pullback, only to see equities recover and the S&P work its way back toward flat on the year. Looking only at where the market stands today misses how demanding the path has been.

That is why The Masters is a fitting analogy. The course may be familiar, but the conditions change every year. In softer setups, players can attack. In firm and fast conditions like this year, precision, patience, and discipline matter more. Markets are no different. The best players at Augusta do not just play the course. They play the conditions. The best investors do the same!

Have a great week!

-Matt

Sources: JP Morgan Asset Management

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

The War Impact

Prior to the first air raid in Iran, capital rotations within the market endorsed our view. Note the performance differential between the S&P Pure Value ETF sporting a 12x P/E vs. the MAG 7 with a 28x P/E, through February:

A 16% performance disparity between these high P/E and low P/E cohorts before the war, within an S&P up 1%, well articulates the point. How about since Epic Fury began:

Clearly, the war hasn’t helped investors. Initially, the higher P/E Mag 7 cohort made a relative comeback (purple line) as investors crowded into comfortable earnings growth bunkers, only to rethink valuations and rotate back to safety (orange line). For the trained eye, this chart conveys the uncertainty present in the marketplace. Will earnings growth persist? Will inflation levels rise? Will economic growth decay? Will the S&P 500 violate technical levels leading to an algorithmic washout? When and where will this market bottom? Where can I hide out until then?

Seeking clarity, I posed these questions to Chat GPT. Chat doesn’t know. So goes the fog of war. Therefore, we can only draw on experience. First, our base case outlook gained validation prior to the conflict and therefore should sustain post. Rotating capital within or across asset classes amidst the fog of war makes little sense as demonstrated above. These are binary moments where investors either raise liquidity (sell everything) or deploy liquidity (buy everything). Trying to game a market being gamed by Truth Social isn’t strategic, its gambling. In unknowable moments, there is safety in stability. Second, because of the anxieties they create, investors often overestimate the economic implications of geopolitical events. Remember the European panic ignited by Russia’s invasion of Ukraine in 2022? European equities actually outperformed American equities that year.  In fact, if you look at past geopolitical events, markets tend to absorb inital shocks and rebound smartly:

The two down years include 9/11, which occurred during the Dot-Com collapse, and the Ukraine invasion which occurred alongside 9% inflation. Those events may have agitated the markets decline, but they didn’t cause it. With our current backdrop of economic and earnings momentum we have a far sturdier foundation reflected in the markets limited drawdown to date. Consider the probabilities of drawdowns in any given year:

In any given year, on average, the market declines by 3% 7.2 times, 5% 3.4 times, and 10% at least 1 time while appreciating 75% of the time. Do I expect this market to pierce the 10% drawdown level, probably.  Do I expect a 15% decline, maybe. Neither would be unusual or insurmountable, especially for a mid-term election year:

Should this market decline accelerate, we will refer to our down-market playbook and reprise our activity seen in April of 2025. We will sell positions to harvest tax losses, locking in future tax benefits, and we will redeploy capital opportunistically anticipating recovery. Remember, down markets have benefits. The valuations that so concerned investors entering 2026 have corrected, making the menu of buying opportunities longer:

In sum, it’s misguided to trade headlines within the fog of war. Should markets move to extremes, mispricing may create opportunities, but any transactions must comply with overall strategic outlooks. Under-trading geopolitical events has produced far higher investment returns for investors than overtrading. Be patient, be opportunistic, and stay the course.

Have a great week!

-David

Sources: YCharts, Factset, Carson Investment Research, Baird, Yardeni Research

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

Inflation Expectations

The Fed’s 1-Year Expected Inflation measure reveals a market that perceives the conflict in Iran as temporary. We received several backward-looking inflation indicators this week that were also largely benign. Most notably, consumer price inflation (CPI) fell to 2.4% year-over-year, its lowest reading in 5 years. This number will surely rise in the next report reflecting higher gasoline prices, and the Fed will most certainly not cut rates next week, but for now inflation expectations sees war driven inflation as transitory.

Investor Sentiment

Aggregate measures of investor sentiment have declined sharply since the war began, but they have not reached capitulation levels. I favor the AAII Bullish sentiment indicator most at times of stress. Whenever the number of retail bulls (the surveyed participants who believe the market will rise) falls anywhere near 20%, an upward market turn typically follows.

With 31.9% still bullish, while we have corrected the froth from 50% a month ago, we have not reached the moribund levels that signal panic, or an imminent advance. 

Volatility

The VIX volatility index provides another investable measure of sentiment. When panic hits, the VIX spikes, but panic typically overestimates negative possibilities presenting a great buying opportunity for investors. For instance, after Trump’s Liberation Day announcement, the VIX spiked above 50 and we became enthusiastic buyers. Trump scaled down tariff rates through negotiations, and the S&P 500 went on to hit new highs.  Currently, the VIX sits at 27—elevated, but not panicky:

The Favorable Fundamentals

When military conflicts and geopolitics command attention, investors tend to lose track of the fundamentals. One can claim that this conflict negates the usefulness of using recent trends to predict future trends, but economic movements contain deep inertia. Prior to the bombing campaign, US economic releases had been steadily surprising economists to the upside:

Simultaneously, Wall Street analysts have been consistently raising forward earnings expectations:

Let’s take a moment here. The chart above chronicles S&P 500 earnings estimate changes over time for the years 2024, 2025, 2026, and 2027. Earnings grew 11.7% in 2024, ending near the high end of the expected range. Earnings grew 13.8% in 2025, also ending near the high end of the expected range. Earnings estimates for 2026 and 2027 have been climbing and now sit at the highest levels of their expected ranges at 15.9% and 17% growth, respectively. This powerful earnings expectations up-force has undoubtedly muted the Iran conflicts downforce. This earnings inertia explains the measured sentiment response and the less than 5% drawdown in the S&P 500 from recent highs.

Have a great week!

-David

Sources: Federal Reserve, YCharts, Yardeni Research, Bespoke Investment Group

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.

The situation in Iran is a reminder that markets do not just price earnings, payrolls, and Fed meetings. They also price shipping lanes, oil flows, and the risk that regional conflicts escalate, adding another layer of uncertainty. This is the core of the Iranian headlines. Iran’s geography gives it leverage in the Strait of Hormuz, where roughly 20% of global oil and liquefied natural gas normally pass this narrow waterway that connects the Persian Gulf to the Indian Ocean, or the rest of the world:

Any disruption to traffic through the Strait naturally raises concerns about global energy supply. As a result of the fighting and escalating tensions, oil tanker traffic in the region has come to a screeching halt. As the chokepoint looks vulnerable to attacks, insurers and re-insurers are no longer comfortable underwriting voyages through the Strait, making it impossible for cargo ships to move freely about towards their ports of destination. The result is visible in the data and in real time:

This chart shows almost zero vessel transits through the Strait. Here’s a map of current tankers on either side of the Strait:

The red circle dots are tankers that have no current course direction. They sit idle awaiting clarity before hopefully continuing their routes.  

For markets, this creates a chain reaction. When energy flows are threatened, we must re-assess oil supply, inflation expectations, and overall risk appetite. The re-pricing has been swift. Crude oil prices and gasoline futures have risen 30% since the conflict started and are up 50% on the year. Treasury yields are up 5-10% across the curve. Treasury volatility is rising after several months of hibernation.

This is the point where the White House narrative runs into reality. President Trump has repeatedly argued that lower oil prices are critical to combat inflation and create room for the Fed to lower interest rates. For much of 2025, that strategy was successful. Energy prices had fallen to levels not seen since before the Russia–Ukraine war, helping ease inflation pressures. However, this week’s sharp rise in oil prices threatens to undo much of that progress. During the 2024 campaign trail, oil prices traded between $70 and $90 per barrel, almost exactly where they sit today after the recent surge. With this week’s breakout in oil prices, Trump has undone much of the progress he’s made in just a few days.

Though the fog of war may be difficult to see through, this provides the most clarity to investors on the situation. The longer oil prices remain elevated, the more difficult it becomes to maintain low inflation and further cut interest rates. In my opinion, this is Trump’s breaking point over the conflict, and recent evidence suggests he understands this dynamic. Last Thursday, Trump publicly called on Iran to lay down their weapons signaling a possible near-term end to the conflict. The administration and the oil aboard the cargo ships sitting stalled in the Middle East would benefit greatly from a swift resolution so that the risk of re-inflation doesn’t come back around.

Still, long-term investors should be careful not to mistake unsettling headlines for a broken investment outlook. History argues for discipline. During the last two Gulf Wars, the S&P 500 enjoyed fruitful rallies in the three and six months post initial Middle East event headlines:

Military conflicts are difficult topics, but ones we must discuss. For disciplined investors, the lesson remains the same: periods of uncertainty are rarely the time to abandon a long-term investment strategy. More often, they are moments when patience and discipline are most rewarded.

Enjoy the rest of your weekend!

-Matt

Sources: Bloomberg, Google Maps, Marine Vessel Traffic, Strategas

This communication and its contents are for informational and educational purposes only and should not be used as the sole basis for any investment decision. The information contained herein is based on publicly available sources believed to be reliable but is not a representation, expressed or implied, as to the accuracy, completeness, or correctness of said information. References to political figures or policies are for informational purposes only and do not represent an endorsement by Waddell & Associates. Any forward-looking statements reflect current opinions and assumptions and are subject to change without notice; actual results may differ materially. Past performance does not guarantee future results. Waddell & Associates may use artificial intelligence tools to help generate or summarize content; all outputs are reviewed by our team for accuracy and relevance.