Dear Friend and Clients, 

 

After a brief pullback of roughly 5% in November—following the longest government shutdown on record—the market rebounded strongly to finish the year up approximately 17%. The Fed has delivered three rate cuts over the past several months and continues to signal additional easing ahead. Inflation remains sticky but manageable, while employment is slowing yet stabilizing—creating a “watchful pause” environment for policymakers.

 

That said, we may be more constructive than most.

 

Looking ahead, we expect heightened volatility as geopolitical risks rise, cracks emerge in the “Magnificent 7,” and valuations remain stretched—leaving markets vulnerable to sentiment-driven overreactions. We will walk through the bear case candidly.

 

As always, we welcome any feedback or dialogue so please don't hesitate to reach out.  

Best regards,

 

Brad Banken, Investment Advisor Representative

 

Allison Banken, COO

 

We are unable to mention specific companies and or tradable investment products in order to follow compliance guidelines as the content cannot be construed as our individual view or recommendation on any investment product.  Please reach out if you have any questions or would like more specific information on anything below.

All performance metrics are as of date of publication.

 

 

Since our last note, markets largely traded sideways into year-end before posting a 1.4% gain in January. The Fed delivered another rate cut in December and signaled a pause ahead however they are still on an easing cycle.  Any further easing will be gradual and data-dependent (with markets currently pricing in a potential June cut). We also saw the 5% pullback in November that we believed was overdue; we would not be surprised to see another in the months ahead.

 

While returns to start the year have been constructive, underlying market dynamics are more nuanced than headline index performance suggests. January continued the trend toward broader market participation and leadership, extending the rotation that began to emerge after the narrow, mega-cap-driven market of 2023–2025. Despite the market being up roughly 1.5% over the past three months, leadership has continued to shift.

 

We've been saying it for some time and continue to beat the drum as to why we believe equal-weight indices, mid-caps, and small-caps offer a more attractive risk-reward profile than mega-cap and technology stocks—and support that view with data.

Seeking Alpha

Seeking Alpha

Historically the market pulls back 5% ~3x a year, sees corrections of 10% ~1x a year and -20% bear markets every 5 years.

Equal weight is leading out of the gates early…. 

Small Caps started the year strong relative to the S&P500 with the second longest streak of outperformance. 

Small caps are off to the second-best start vs the Nasdaq in 35 years. 

Seeking Alpha

In January the Mag 7 was flat as Emerging Markets were up 11%, Small Caps (Russell 2000 Index) was up 6.5%, and Equal weight was up 3.2%.

Year to date 62% of SP500 stocks have outperformed the index, the highest share since 2001 vs the last three years with only ~29% outperforming (b/c Mag 7 dominated). 

The Tech sector delivered earnings to fill in the very high PE multiple valuations during the full year 2025. 

Last year saw the earnings fill in the multiple growth from 2023 and 2024 and we will continue to think they will drive the bus this year.

Despite strong interest in AI, valuations for AI-related stocks declined over the past year, while non-AI stocks saw rising valuations.

We'll lay out some potential headwinds adding fuel to the bear case along with some illustrative charts and then do the same for tailwinds for the bull case. 

 

Valuations: Large-cap stocks and the S&P 500 are trading at elevated valuations across nearly all major metrics.

AI expectations: Heavy investment in AI has driven very high profit expectations, increasing the risk of disappointment if growth fails to materialize quickly.

Investor sentiment: Sentiment is at its most extended level since July 2021, historically a cautionary signal.

Consumer sentiment: Measures from the University of Michigan and the Conference Board show consumer confidence near 12-year lows—levels last seen during the 2001 and 2008 recessions.

Mean reversion risk: After three consecutive years of gains exceeding 15%, the market may need time to digest returns and revert toward longer-term averages.

Earnings sensitivity: Much of the “good news” around AI appears priced in. Microsoft’s solid earnings were not enough to meet expectations, resulting in its worst single-day decline in over a decade and pressuring the broader software sector.

Political risk: The approach of midterm elections could amplify social and political tensions, increasing headline risk and market volatility across both parties.

Historically, current valuation levels have been associated with low single-digit annualized returns over the next five years. However, we will outline why this comparison may not be entirely apples to apples. In the 1950s, nearly 100% of S&P 500 revenues were generated domestically. By 2002, that figure had fallen to roughly 35%, and today it stands near 41%.

 

An increasingly global revenue base may offer greater long-term growth potential and more valuable diversification than in prior market cycles.

Also, the Equal weight tells us a very different picture….

Could Big Tech miss on earnings because they can't monetize their investments?  Yes, but it's hard to draw comparisons to the internet bubble given Big Tech is funding investments with internal cash flow. 

Large cap Tech is selling off and some are in bearish territory 

 

January Barometer: A positive January has historically been a constructive signal for full-year market performance—does that pattern hold this time?

Tax relief tailwind: Estimates suggest tax relief could add roughly $344 billion on an annualized basis, translating to ~8.3% real disposable personal income growth in Q1.

Manufacturing inflection: Early signs of improvement are emerging as onshoring, infrastructure spending, and foreign investment gain traction. Notably, the ISM Manufacturing Index moved back above 50 last month after nearly three years in contraction.

Valuations vs. profitability: Can current valuations be justified in the context of record-high profit margins relative to prior market cycles?

Inflation skew: Inflation risks may be tilted to the downside. Alternative measures suggest inflation is running below 2%, shelter rents continue to ease, and tariff-related core goods pressures will roll off in the second half.

Earnings resilience: Earnings remain the most critical driver—and they continue to surprise to the upside, with expectations showing little sign of slowing. We will compare Big Tech versus the broader market, as well as the S&P 500 versus small caps.

Cash on the sidelines: Over $7 trillion remains parked in money markets and cash. As rates decline, will this capital rotate into higher-yielding or higher-risk assets?

Cycle perspective: Historically, bull markets last an average of 4.6 years and generate ~157% cumulative returns. We are now in year four, with gains of roughly 83%.

AI adoption: AI adoption continues to accelerate, supporting productivity and long-term earnings growth.

 

January was up 1.3% so historically going back to 1950, the average year is positive 87% of the time with a 13.4% average return.   If Jan is negative, the average year is positive 60% of the time with a 3.5% average return.

Manufacturing momentum: New Orders posted the largest month-over-month increase (excluding the COVID period) since 2001. The headline ISM Manufacturing Index rose to 52.6 from 48.5, moving back into expansion territory, with Backlogs, Employment, and Production all exceeding expectations.

Profit margins are at record highs. If margins are structurally higher—roughly 14% today versus ~10–11% during the 2010–2020 decade—shouldn’t that justify higher valuation multiples?

While large-cap margins have accelerated since 2023, mid- and small-cap margins have improved at a slower pace. Could the AI infrastructure build and lower rates create upside potential for smaller-cap margins?

Revenue per worker has been accelerating and is breaking out to new levels after two decades of declines.  Once again, can you compare valuations vs the 90s with rev/worker ~.21 vs ~.15 or ~50% higher? 

Small caps are the most sensitive to cost savings and have a few tailwinds lining up.  Lower interest rates are one of the biggest as most of them have variable loans.  Most small caps are domestic so on shoring and tariffs should help as well. 

Earnings continue to show solid growth

The divergence between Mag7 earnings and the other 493 names are narrowing

The Small and Mid Caps earnings are diverging from the large caps as well

Small Cap earnings relative to S&P500 have started to turn

Could small caps see more relative outperformance? 

Corporate earnings and guidance estimates show the market expecting ~15% earnings growth in 2026 and 2027.   2025 earnings were margin driven and there are no signs of slowing down.  Earnings in 2025 grew 11.5% last year. Of that 11.5%, ~7% was margin driven  vs the historical average of 2.2%.  This is while revenue growth was better than average as well at 5.5% vs 4.9% average. 

The earning season wrapped up in December; it is worth noting the number companies that guided positive was above average and the number of companies that guided lower, were below average.  Earnings are showing no cracks yet but will continue to monitor.  

 

Current full year estimates call for S&P500 earnings to be +15%, Mid Cap S&P400 +17% and Small Cap S&P600 +19%.

Macro and Inflation:

 

The CPI in December annualized at 2.6% down from 3% in September.  The largest item for the monthly increase was Shelter at 3.2%.  Shelter was 48% of hte monthly increase 42% of the year over year increase.   Now we will give a different perspective.

The Core CPI(excludes Food and Energy) was up 2.63% matching the lowest level of core inflation since March 2021.  Gas prices are the lowest they have been since early 2021.

 At the risk of sounding like a broken record, it's worth repeating: 

CPI and PCE—the Fed's two preferred inflation gauges—are, in our view, outdated and lagging indicators. Much of the attention is on shelter inflation, which is both miscalculated and backward-looking in the CPI. We continue to favor Truflation, which pulls from around 30 million real-time data points, compared to just ~80,000 used in the CPI.

Rental growth rates have been negative since mid 2023.  Rental vacancies are up 7.1% in the US year over year as well. 

 

Political and geopolitical noise: Headlines are likely to grow louder, with potential flashpoints around Venezuela, Greenland, Iran, the Fed Chair, and U.S. midterm elections. We continue to focus on the quieter but more durable backdrop of strengthening economic fundamentals and a broadening market narrative reshaping equity leadership.

 

Fading macro headwinds, emerging tailwinds: Tariff-related uncertainty appears to be easing, while AI and data center spending shows no signs of slowing. A potential “second wave” of AI investment may flow from hyperscalers to smaller companies, driving productivity gains and cost efficiencies. Additional tailwinds include a weaker dollar improving U.S. export competitiveness, lower oil prices, World Cup-related activity, and the OBBB legislation—which eliminates federal income tax on overtime pay and tips, raises the child tax credit to $2,200 per child, and extends 100% expensing for equipment and factory investments to encourage capex, hiring, and investment. Some estimates suggest OBBB alone could boost GDP by ~0.9% in 2026. Inflation has not been below 2% since early 2021—could we see a drift back toward 2% this year?

 

AI still early innings:  AI investment has been rapid and there is little evidence of slowing. The U.S. spent roughly $500 billion on data centers in 2025 alone, with total AI infrastructure spending projected to reach an additional $5–8 trillion through 2030. This buildout may still be in its early stages.

 

Market breadth signal: The S&P 500 has recorded seven new one-year highs over the past three months, while the Nasdaq has yet to make a new high. Historically, this pattern has been followed by higher S&P 500 returns nine months later, averaging approximately 12.2%.

 

Election-year stimulus potential: If history is a guide, a market-friendly administration heading into midterm elections could generate a wave of pro-growth or “stimulus” headlines, including:

Could 2026 be defined by above-average economic growth, easing monetary policy, accelerating productivity, lower inflation, stable employment, a manufacturing resurgence—and, most importantly, above-average earnings growth?

 

India: India lagged last year, returning roughly 4%, as it sat in the geopolitical crosshairs of tariffs and trade uncertainty.  They recently signed a major trade agreement with the European Union and reached an understanding with the U.S. regarding Russian oil purchases. We remain constructive on India’s long-term outlook over the next decade.

 

Real assets and strategic materials: Precious metals, copper, and nuclear-related themes performed well last year and we continue to see headlines of continued investments/cap ex spending in these spaces. The launch of “Project Vault” aims to strengthen U.S. supply chain security by building strategic mineral reserves and reducing reliance on China. We continue to favor these themes structurally while acknowledging that recent rallies may warrant selective trimming.

Questions? Feedback?  Drop us a line at info@oakstreaminvestments.com

 

(908) 271-8788

The opinions and forecasts expressed are strictly those of Brad Banken's and may not actually come to pass.  

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