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The Retired Investor: The U.S. Stock Market Is Just Too Big To Fail
The Retired Investor: AI and the financial markets
PITTSFIELD, Mass. — Has the artificial intelligence boom gone too far, too fast? Traders recently have decided to sell first and find out later. Is this simple profit-taking or something more insidious?
In my last column, I examined how equity investors have bid up stocks in the AI area for more than a year. A feedback loop of higher earnings expectations in the group triggered higher prices, which reinforced even higher earnings. Looking under the hood, I questioned some of the accounting moves that have driven these earnings in the past.
The market is now looking for a 30 percent jump in earnings results versus last year as third-quarter earnings are underway. In many respects, the fate of the economy and both the stock and bond markets now depends upon what happens in the AI sphere. That may sound like an exaggeration, but consider this. Goldman Sachs’s head equity analyst expects more than half of third-quarter earnings to come from 10 stocks, with more than one-third of that coming from just two companies.
And what is happening in the stock market is also happening in the bond market. In the corporate bond world, AI-related bond transactions accounted for over 50 percent of all investment-grade issues as of the end of August. Appetite for these AI offerings has been so strong that, for example, a Microsoft bond issue was preferred over government bonds of the same duration.
Apollo Management estimates that the bond market will raise $1.8 trillion by the end of this year. This is part of why bond yields have risen as much as they have. Between the U.S. government’s need to finance our debt and AI companies in the private sector, the supply of newly issued debt has overwhelmed demand.
That doesn't include the "off-book" borrowings that Microsoft, Alphabet, Amazon, Meta, and Oracle have taken this year. Those obligations amount, at last count, to $1.65 trillion in hidden, off-balance-sheet debt. These include future obligations like long-term operating leases for data centers yet to be built, bulk GPU supply contracts, and joint ventures. Accounting rules say companies don't have to record these liabilities on their balance sheets until after the assets are delivered or go live.
And speaking of pros, guess who has become big players in both AI stocks and bonds as well as U.S. Treasury bonds—hedge funds. This is according to a recent International Monetary Fund (IMF) report. The IMF is sounding an alarm about the growing risk hedge funds represent to the global financial markets.
These risky, private investment firms are leveraged entities that have doubled their assets in the last 6 years to about $13 trillion. A little more than half that amount is borrowed money. They invest alike. They are all up to their ears in the same AI stocks, as well as the same Treasuries and AI bonds. Their share of the U.S. Treasury market is more than 12 percent right now.
These are not buy-and-hold money managers or pension funds. They borrow money and buy stocks and bonds. If the trade goes against them, they are quick to sell out. Usually, they do so en masse. In the first quarter, their combined assets under management, plus the face value of their derivatives, were estimated at $42.2 trillion. That leaves us with a highly concentrated market, dominated by a mercurial group of players. A large portion of the retail crowd backs them, and are far more focused on the narrative than the numbers.
That narrative, however, is real enough. The global macro picture on AI is clearly on track. Like the internet before it, AI is real and promises to transform society yet again in the years to come. That doesn’t mean the AI space, like the internet before it, can’t get over its skies on occasion.
I don’t think we will see a protracted decline like the dot.com bubble where 50 percent or more of those companies disintegrated in the early 2000s. Remember, it took years for the boom-and-bust cycle of the Dot-Com era to unfold. What worries me most is the degree of AI concentration risk on both sides of the bond-and-stock market equation. Between the hedge funds and the 50 percent weight of the big tech players in the S&P 500, let’s hope third-quarter earnings are better than expected.
The Retired Investor: Corporate profits better be good
Third-quarter corporate profit results kick off this week. A lot is riding on what company management tells Wall Street. Both the stock market's present and future fortunes depend on what they say.
It has been an extraordinary year for revenues, profits, and profit margins for many companies listed in the benchmark S& P 500 index. In the second quarter alone, earnings results were 50 percent higher than they were last year. This time around, investors expect a further 29 percent to 30 percent increase over 2025. That’s good news and makes great headlines, but the truth is that a relatively small handful of stocks are responsible for such stellar results.
None of us should be surprised that artificial intelligence is the engine of growth behind this remarkable performance. And while these technology stocks will generate the lion’s share of earnings, they won't generate all of it. You see, while companies like Micron Technology and Nvidia benefit greatly from the AI infrastructure buildout, AI is boosting business for just about everything from construction companies to copper miners.
One caveat the reader should note, however, is that most companies on the receiving end are booking the $166 billion in tariff refunds occurring now (due to the illegality of Trump’s first round of tariffs) as profit. In a past column, I predicted that little, if any, of this money would be returned to the consumer (who paid 90+ percent of these tariffs). As a result, these refunds are partially responsible for record profit margins throughout the economy.
As readers know, I use the S&P 500 Index as my benchmark when analyzing the market’s fortunes, since most other markets key off its performance. Thanks to AI, the technology sector now represents about 40 percent of the index market capitalization. However, neither Meta nor Amazon, two of the largest hyperscalers, are included in that index. If you include them, the AI-related weighting of the S&P 500 is almost 50 percent.
But let’s get back to earnings. In the second quarter, the top contributors to the massive earnings gain were Amazon (+242 percent) and Alphabet (300 percent). To bank those gains, a lot of people would have had to spend most of each day online buying everything Amazon offered. As for Google, I’m not sure it would have even been possible- without an accounting twist. For both companies, much of their profit came from huge, non-operating, unrealized gains on their private equity stakes in other tech companies (read: AI darlings Anthropic and SpaceX).
How would corporate results have fared without that accounting treatment? Second-quarter earnings would have dropped from 47.7 percent to 28.8 percent if you excluded just these two companies’ profits from these investments. Rest assured, they weren't the only two companies that used this accounting convention. I’m sorry to get all wanky on this, but that’s not the only accounting smoke and mirrors involved in the AI investment boom.
General accounting practices dictate that a company's wages and other expenses are deducted from its sales. What is left over is profit. However, large capital expenditures are treated differently. An AI company can plunk down $300 billion for data center or three, but it doesn't subtract that cost from revenue. Instead, it's listed as property on the company’s balance sheet. As such, they recognize the costs only over time as the value of this property declines due to wear and tear, etc.
And now the plot thickens. At the same time, all these billions of dollars are being spent on infrastructure; the Nvidias of the world that sell semiconductor chips, GPUs, CPUs, and the like to big hyperscalers like Microsoft and Alphabet get to book their sales and profits immediately.
Bottom line: the huge AI infrastructure price tag is dramatically understated and pushed into the future. That accounting standard softens the impact on earnings, while the profits of the various AI spenders are booked immediately and are overstated.
Together, these accounting principles create a virtuous circle: more AI spending guarantees higher sales and profits for companies. That translates into higher prices for the individual stocks, both private and public. In the case of private company shares held as investments by some hyperscalers, more unrealized gains can be booked as income.
How does this merry-go-round end? This bubble will burst, but only after investors and Wall Street analysts alike start looking under the hood and not just the headlines, do the work, and start coming up with their own conclusions. It took years during the early boom-and-bust cycle of the Dot-com era for this to happen. In this case, some early calls for caution are beginning to be heard.
But it is not only the stock market where the AI mania has caught hold. Next week, I will discuss how AI companies have been forced to either raise new rounds of equity or tap the bond market for funds now that their cash flows have been depleted. I also look at another player that has entered the fray and what that may mean for AI in the near term.
The Retired Investor: Could Higher Bond Yields Simply Reflect a Stronger Economy?
PITTSFIELD, Mass. — Over the last month, equity investors have grown concerned with the rapid rise in U.S. Treasury bond yields.
Higher interest rates should spell danger for stocks. And yet, equities are still less than 2 percent from all-time highs. What gives?
Many financial experts say bond yields are rising because of oil prices, inflation, out-of-control government spending, Trump tariffs, and anticipation of Fed rate hikes. What if the explanation was much simpler? Could higher bond yields simply reflect a stronger growth economy?
This isn’t a new concept. The higher growth/yield correlation occurred in 1994, 2009, and 2012. In fact, financial history is rife with similar correlations. The underlying dynamics are straightforward. When the economy grows more rapidly than expected, consumer spending and business investment increase, as does the stock market. That’s a good thing if it doesn’t contribute to higher inflation.
To prevent the economy from overheating and triggering more inflation, central banks often raise interest rates to make borrowing more expensive. As readers know, the U.S. Federal Reserve Bank has begun an interest rate tightening cycle at its September meeting. The odds that they will tighten again in October have come down. It is perfectly natural for bond yields to rise in anticipation of a hiking cycle.
That is exactly what at least one eminent Fed president sees in this recent climb in bond yields. I caught a CNBC interview with New York Fed President John Williams, a permanent voting member of the rate-setting Federal Open Market Committee, last Wednesday. He remains in the wait-and-see camp among Fed Heads, while others are clamoring for more hikes.
On Tuesday, in prepared remarks, he said, "With the policy action we took at our September meeting, there is no need for urgency, and we have time to gather more information."
Williams is one of those Fed figures I pay attention to because he has a great deal of experience in the financial markets and keeps his cool when others don’t. When asked about yields, he said, "What’s driving it, in large part, is a really strong economy and a strong economic outlook fueled by big investments in AI and data centers and technology in general."
Williams laid out his base case for interest rates when he said: "If the economy evolves in a manner broadly consistent with my forecast, one further upward adjustment of the federal funds target range may be appropriate late this year to support a timelier return of inflation to target."
One way to see whether inflation or growth is driving the climb in bond yields is to determine which has moved more: real yields (nominal rates minus the inflation rate) or inflation expectations. Real yields reflect the market’s expectations of the economy's underlying strength. It is usually measured by looking at the rates on U.S. inflation-protected U.S. Treasuries called TIPS.
To see how much of a yield move is driven by inflation expectations, you measure the difference between TIPS yields and those of regular Treasury securities maturing around the same time. The gap between the two should give us an idea of what investors think the inflation rate will be during that time.
Axios Markets, a well-respected financial newsletter, crunched the numbers and discovered that over the last month the five-year real yield accounted for 0.72 percentage points in the rise in the five-year Treasury note. Inflation expectations only accounted for 0.06 percentage points of the move. Some may find that hard to believe.
Yes, I'm aware of all the consternation around the economy's inflation, but there are compelling reasons to believe the yield spike is a growth story. Second-quarter Gross Domestic Product was revised up to a 2.2 percent annualized growth rate from the previously reported 1.5 percent.
Consumer spending grew at a healthy 3.8 percent annualized pace, while stronger business investment contributed to the revision. Consider that the artificial intelligence revolution has sparked the largest capital investment boom in American history. Goldman Sachs analysts project AI spending will reach $1.3 trillion in 2027 and $2 trillion in 2028, in addition to the trillions of dollars already spent. As a result, corporate profits have grown between 20 percent and almost 30 percent per quarter for the last few quarters. The unemployment rate is at 60-year lows. That is a heck of a case for the growth/yield story.
Granted. For the ordinary worker, struggling with mounting energy bills, affordability issues, and the like, it certainly doesn’t feel like growth. In fact, American laborers are receiving the smallest share of income from these economic benefits in our nation's history. Of course, every two years, these same workers can change that equation if they so choose through the ballot box. Recently, they have chosen not to.
The Retired Investor: The ailing housing market is getting sicker
It's as if the world is against homebuilding. As mortgage rates top 7 percent, a combination of higher prices for key inputs, thanks to tariffs and the Iran war, has already decimated the sector. And yet, there is worse news for builders. ICE-inflicted labor shortages are suffocating profits and growth.
From the East to the West Coast, home builders are complaining bitterly about the administration's current immigration enforcement efforts. This year, ICE's efforts to redouble its arrests at the insistence of the White House have resulted in a surge of arrests of "illegal aliens."
And while the numbers may satisfy some in the country, they are causing consternation among the nation's homebuilders. A survey by John Burns Research and Consulting, which tracks market trends in the industry, found that the administration's immigration actions are causing severe labor shortages. This worker shortfall is driving up costs and delaying cycle times for new home construction.
Three straight months of record arrests this summer have convinced many legally authorized workers across the housing sector to stop showing up for work. Many fear that despite their legal status, if they are caught up in an ICE sweep, they could be easily deported or spend months in detention and incur huge legal fees before their status can be adjudicated.
They point to the fact that in recent months, ICE has coordinated with immigration courts to dismiss many noncitizen removal cases and immediately arrest individuals so they can be processed for expedited removal. As a result, a noncitizen but legal immigrant has little opportunity to contest or seek other relief if caught up in an ICE sweep at a construction site or factory.
Overall, immigrants comprise more than 26 percent of the construction workforce in the U.S., although that share can be even higher depending on the trade. Those in drywalling, ceiling installation, plastering, stucco masonry, roofing, painting, paper hanging, and carpet, floor, and tile installations account for more than 50 percent of workers in construction trades.
This shortage is nothing new. In a landmark 2025 study by the Home Builders Institute, the National Association of Home Builders, and the University of Denver, the study found that the skilled labor shortage in the single-family home building sector is costing the U.S. economy around $19 billion a year.
The AI boom in private data center construction has also siphoned off a swath of the existing labor pool. Through July of this year, $37 billion was spent on AI data center construction compared to $46 billion for construction of everything else, from houses, apartments, shopping centers, etc.
Add the 6.7 percent increase in building material costs, driven by tariffs and conflict-driven inflation, and you have a pretty good idea why your children can't afford to buy a home in America today.
Readers may recall that Donald Trump's immigration policies were intended to remove "Tens of Millions of Illegal Alien Criminals who poured into our country, including Hundreds of Thousands of Convicted Murderers, Rapists, Kidnappers, Drug Dealers, and Terrorists," according to a January 25th social media post by the president.
It is notoriously difficult to determine exactly how many arrests and deportations of criminal illegal immigrants have been accomplished. That alone should tell you something about the government's success rate of capturing criminal illegals. If you have a documented number, I would be grateful to know it.
As of the end of the government's 2025 fiscal year, the Cato Institute found that 73 percent of arrested illegals had no criminal record. Other news sources say less than one-third have any criminal conviction. I guess one can argue, as this administration must surely be doing, that because someone crossed into this country illegally, they are a criminal by definition.
I'm equally sure that few who may have agreed with the president's social media post (quoted above) would consider their nanny, hospital attendant, roofer, house painter, fruit picker or grass cutter fit Trump's definition of a criminal. It appears that those red-blooded Americans who build houses for a living (many of whom reside in Red States) are becoming increasingly dissatisfied with the present immigration policies of the United States. How about you?
Bill Schmick is a founding partner of Onota Partners, Inc., in the Berkshires. Bill's forecasts and opinions are purely his own and do not necessarily represent the views of Onota Partners, Inc. None of his commentary is or should be considered investment advice. Direct your inquiries to his website at www.schmicksretiredinvestor.
