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Over the past few months, the markets have gradually become more uneasy about the gigantic spending of AI companies, much of which is spent inside the AI ecosystem, driving profits and valuations.

As long as the hyperscalers were spending their free cash flow from their existing profitable businesses this wasn’t such a problem. But now they (and smaller AI-involved companies) are borrowing such huge amounts that they are forcing even the Treasury yields higher. And the stock market bubble is driven by the familiar dynamics of borrow - overbuild - delayed adoption - bust that have occurred several times over the past couple of centuries.

The concentration of stock index growth in a few AI companies is a risk to the many investors who buy and hold index funds.

wsj.com - The earnings boom is heavily reliant on just a handful of stocks

Analysts expect S&P 500 companies to report a 30% jump in third-quarter earnings from a year ago, driven largely by a handful of AI giants.
Just two companies, Nvidia and Micron, account for 34% of the projected S&P 500 third-quarter profit growth.
Analysts warn that concentrated earnings growth poses a risk if artificial-intelligence technology fails to deliver on the massive investments.

Just two companies — Nvidia and Micron — account for 34% of third-quarter earnings growth from a year ago, according to a Dow Jones Market Data analysis.

And only 10 companies— including Broadcom and Meta Platforms —account for roughly two-thirds of the profit growth. Others include oil-and-gas giants that benefited from higher energy prices caused by the conflict in Iran...

Even as earnings estimates surged this year, share prices — for the market and the firms driving the growth — have moved relatively little in comparison. That means equities look cheaper than they did at the start of the year. ... [end quote]

Due to rising bond yields and concern about AI spending, the forward 12-month P/E ratio has been declining into a reasonably sane level. (Bond yields impact the share prices of “growth” companies because the calculation of the Net Present Value of future expected earnings is discounted exponentially by the cost of borrowed money.)

While the forward P/E looking ‘sane’ is comforting on the surface, the real story is the Equity Risk Premium (ERP). With real yields on 10-year TIPS near 2.6%–2.8% and nominal long-term Treasuries offering high guaranteed yields, stocks are offering almost no yield premium over risk-free bonds. Passive investors holding market-cap-weighted index funds are taking on concentrated mega-cap tech risk without getting compensated by the traditional equity risk premium.

Junk bond spreads have spiked to over 13%. The CCC & Lower US High Yield Index Effective Yield is 18%. Unless free cash flow shows up soon, zombie companies will be forced into borrowing to pay interest or default. This includes AI companies that aren’t cash-rich hyperscalers.

Much of the non-hyperscaler buildout is funded via private credit and GPU-collateralized loans. If adoption lags, the first credit fissures will show up in private debt and structured finance long before hitting hyperscaler balance sheets. Search "Alternative Asset Managers & Mega-Cap Private Credit Giants" for a list of companies to potentially short if that's your bag.

The CAPE shows that the SPX is in a historic bubble. But since this is a 10 year moving average it’s slow to respond to recent changes.

The SPX has been in a plateau channel since August. The NAZ has been in a volatile gradually rising trend since May. NAZ bullish percent has dropped to 40. VIX has spiked to about 20, which shows nervousness but not a crisis level.

The Fear & Greed Index is in Extreme Fear. The trade is risk-off. Fearful investors are buying Treasurys relative to stocks and junk bonds to the extent that the entire Treasury yield curve fell last week, especially long-dated Treasuries. The 30 year Treasury yield hit 5.7% (the highest since 2002) before falling back.

The 30 year TIPS yield hit 3.35% before falling back to 3.0%. The 10 year TIPS yield hit 2.87% before falling back to 2.64% - the highest since the Great Financial Crisis in Nov. 2008. These yields would be irresistable to bond buyers - UNLESS interest rates climb further in the future due to excess borrowing and the fear that the government will change the way the CPI is calculated to suppress the reported inflation rate.

The Cleveland Fed’s inflation Nowcast shows 4Q26 CPI over 5%. This made me gasp since it’s been decades (apart from 2022) since inflation was over 5%.

The Atlanta Fed’s Third-Quarter GDPNow Estimate for 2026:Q3 is 3.5%, similar to their “Blue Chip” consensus which usually is much lower. This is a strong growth reading. The options market doesn’t expect any fed funds rate change this week but a strong likelihood of a raise in December.

The Chicago Fed’s National Financial Conditions Index (NFCI), which provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets, and the traditional and “shadow” banking systems, shows stable, very loose financial conditions.

Oil and diesel prices continue to rise. This feeds into rising inflation all through the economy.

Gold and silver continued to fall. Bitcoin stabilized after a recent small spike.

The METAR for next week is similar to last week. Cloudy with periods of rain. I don’t expect any sudden change until after the election.

Wendy

cmegroup.com - Cme fedwatch tool