Despite the war with Iran and high inflation readings, the stock market had its best quarter since the post-Covid rebound in 2020; the second best since 1998. Still, the rally did not cure the issues we have been writing about. The markets climbed this quarter as problems were mostly paused rather than solved. Meanwhile, parts of the technology sector are again priced as if nothing can go wrong. The returns for the major domestic stock market indices were:
| Q2 2026 | Year to Date | |
|---|---|---|
| S&P 500 (Large Cap) – Market Weight | +15.20% | +10.21% |
| S&P 500 (Large Cap) – Equal Weight | +10.90% | +11.59% |
| Russell 2000 (Small Cap) | +21.15% | +22.24% |
Economic Overview
When we wrote to you in April, the Strait of Hormuz was closed, oil prices had surged more than 60%, and the word “stagflation” was creeping back into circulation. Things improved during the quarter. In mid-June, the U.S. and Iran signed a temporary ceasefire meant to buy time to negotiate an actual end to the war. The hardest issues were deferred, and isolated attacks have already flared. We said in April that wars are easy to start but far harder to end, and nothing since has changed our view.
For portfolios, one thing to watch is the price of oil. During the quarter, oil fell nearly all the way back to pre-war levels. The market, in other words, had already collected on a peace that has not been signed. As of this writing, the ceasefire was no longer in effect, new attacks have occurred, and prices are once again rising.
While oil has been gyrating, inflation kept climbing. Headline CPI hit 4.2% in May, the third straight month of acceleration, as the spring’s energy costs worked their way through the economy. The core reading, which does not count food and energy costs, is a milder 2.9%. That gap tells you this is mostly an energy shock, and the Fed’s hard decision is whether to treat it that way or to fight it with higher rates.
Jerome Powell’s term ended in May, so that decision falls to a new chairman, Kevin Warsh. At his first meeting in June, the Fed held rates steady, but its projections flipped from expecting a cut this year to leaning toward a hike, and half its policymakers have penciled one in. Raising rates into a job market that produced only 57,000 new jobs in June would be a serious test for a stock market priced as richly as ours is at present. That is not our base case, but it is the clearest way the second half could go wrong.
Importantly, while the Fed directly sets the target for overnight interest rates, it has less influence on long-term rates. Investors domestic and foreign buying and selling bonds, loans, and other debt instruments determine the rates that are acceptable for any given borrower at any given maturity. As with any product, the more supply, the lower the price. In the case of bonds, a lower price translates to a higher interest rate. For various reasons including tax cuts and war costs, investors are being asked to absorb heavy Treasury bond issuance while inflation runs at 4%. We doubt they will accept low yields in that environment.
We mentioned above that the word stagflation came back into circulation last quarter. Weak job growth, sticky inflation, and a troubling fiscal picture all highlight that stagflation remains a real threat. Concern was paused, but it is very much still there.
Markets
On a very positive note, the rally in Q2 was boosted by strong earnings and corporate guidance for more of the same. S&P 500 earnings increased by more than 27% year-over-year in the first quarter, and the consensus is for growth of roughly 23% in the quarter just ended. Analysts actually raised their estimates as the quarter progressed. They usually do the opposite. It is worth noting that forward P/E (price to earnings) ratios are generally lower now than at the beginning of the year.
Even though large-cap stocks led the markets higher, it wasn’t the so-called Magnificent 7 that led the way this time. We’ve talked before about the wide valuation gap between large-cap and small-cap stocks, and that gap began to close during the quarter as the Russell 2000 index gained 21.15%, giving small stocks their best first half showing since 1991.
For example, several months ago, Microsoft could do no wrong. The stock has since fallen sharply, about 30% at present, from its October high on fears that AI company Anthropic will overtake Microsoft’s enterprise software business. Microsoft is not standing still, and in fact has a large investment in Anthropic. Whether the fears prove out or not, the market repriced one of the world’s largest franchises in short order.
Look under the hood, however, and the small cap rally runs on the same engine driving the large caps. Chip-related companies account for 16 of the Russell 2000’s 50 best-performing stocks this year. The market broadened in name, but much of the gain is still the same bet on the same theme. An index list can contain a vast number of companies and yet still entail unhealthy concentrations in specific sectors and sub-sectors.
The spending behind that engine is real, showing up in orders and in earnings. Nvidia’s latest numbers show revenue growth of 85% year over year and earnings growth of over 200%, and the Philadelphia Semiconductor Index just had the best quarter in its history. Micron (up 242%), Intel (up 216%), and Advanced Micro Devices (up 186%) added a combined $2 trillion in market value in three months.
And there is a bigger question behind all this spending: how many large language models do we really need? China sharpens it by encouraging open-source AI models, effectively giving away what U.S. companies are paying fortunes to build and hoping to sell. Each U.S. company feels it must remain closed-source in order to recover its investment, which hands China a cost advantage worth watching.
The buildout is also meeting resistance on the ground. Data centers need land, power, and water, and the communities asked to provide them are increasingly saying no. Local opposition blocked or delayed roughly $130 billion of projects in the first quarter alone, about as much as in all of last year, and rising electricity bills have made data centers a campaign issue in both parties. That resistance will not stop the buildout, but it can slow the pace and raise the cost, and with the midterms approaching the issue will not stay local.
As for what the market is willing to pay these days, SpaceX went public in June in the largest IPO in history, raising $75 billion at a valuation of roughly $1.75 trillion, and the stock ended its first day of trading worth nearly $2.2 trillion. It may be an exceptional business, with leading positions in orbital launch, satellite internet, and AI-related infrastructure. It is also a company that generated $18.7 billion of revenue last year and lost money doing it. At that price, an investor needs trillions of dollars of new value creation just to double their money. We would rather admire the rockets than chase the stock.
In healthcare, Eli Lilly is at the forefront of weight-loss and Alzheimer’s drugs and is using AI to speed up new discovery. Some of the money being shifted into Lilly is coming from Pfizer, which is still a solid name but now faces a wave of patent expirations over the next few years with an uncertain pipeline behind them.
There are a variety of historical measures suggesting that market values are unsustainably rich. P/E ratios remain high, and the Shiller P/E ratio, which smooths ten years’ worth of earnings against current prices, hit a recent high matched only at the peak of the 2000 tech bubble. The counterargument is that we were valuing stocks based on clicks back then, while today’s leaders are strong companies with real earnings.
It has been largely counterproductive to try to pick tops in this market. We tend to let profits run and in some cases use protective stop orders as a defensive measure to limit drawdowns. When we do get stopped out of a small portion of an overall position, it is very often at a higher price than where the stock traded two months earlier. In balanced accounts, rebalancing to targets after sharp swings in either direction also serves to reduce volatility. And as always, we employ analytical tools to make sure that you are properly diversified and that your money is deployed as productively as possible on a risk-adjusted basis.
This is true in fixed income as well. Given political instability, inflation, and a worsening federal deficit, it has become increasingly likely that interest rates may rise – long-term rates especially. In addition to providing yield, it is important that bonds retain principal value to help stabilize one’s overall portfolio and also provide ‘dry powder’ to shift into cheap stocks upon equity market dips. We thus remain conservative on this front, holding mostly Treasury bills and for most clients a diversified block of high-yielding, short-term and floating rate closed end funds. The overall effect is to yield just over 5% but with excellent stability and liquidity. As economic conditions change, we can quickly adjust when beneficial.
We are pleased to report good results for the past quarter. We are equally pleased to be at your disposal any time you need help with planning issues or any other financial matters. We hope you had a great July 4th celebration and wish you a very happy summer.