Records on the Surface, But Strain Underneath

If the second quarter was a lesson in how much negative news a market can climb over, the third quarter was a lesson in how misleading a headline number can be. On the surface, things looked perfectly fine. The S&P 500 gained about 2% for the quarter, the Nasdaq Composite added roughly 2.5%, and both set fresh record highs along the way. But peel back a layer and the picture changes dramatically. The Dow Jones Industrial Average fell about 2.7%, the Russell 2000 gave back more than 7.5% after its spectacular spring, and by quarter-end the typical S&P 500 stock was sitting more than 15% below its 52-week high. In other words, a handful of AI-linked giants kept the scoreboard green while much of the market quietly slipped into a correction of its own. All of this happened as the Iran war came roaring back, oil climbed roughly 30%, the 10-year Treasury yield punched through 5%, and the Federal Reserve raised interest rates for the first time in three years. Several forces, discussed below, explain both why the major averages held up and why so much of the market underneath them did not.

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The Collapse of the Hormuz Peace Deal and Oil Shock Round Two

When we wrote in July, the June 17 memorandum between Washington and Tehran had reopened the Strait of Hormuz and drained much of the war premium out of oil. That optimism was short-lived. Iran fired on vessels ignoring its transit “protocols,” the U.S. reinstated sanctions, and the ceasefire collapsed on July 8–9. A later truce lapsed in mid-August, and on September 27 President Trump rejected Tehran’s latest proposal to reopen the strait. WTI crude rose about 30% to roughly $90 a barrel, and Brent neared $108.

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The Bond Market’s Revolt

If one chart defined the quarter, it was the 10-year Treasury yield. It rose roughly 85 basis points, its largest quarterly jump in years, ending near 5.29%, a level not seen since 2007. The global selloff was fueled by stubborn inflation, a Fed pivoting toward tightening, and unease about government borrowing, which drove mortgage rates back above 7%.

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The Fed’s First Rate Hike in Three Years

New Federal Reserve Chairman Kevin Warsh made good on his hawkish tone. The Fed held rates steady in July, though three governors dissented in favor of a hike, and at Jackson Hole Warsh called inflation “the predominant focus.” On September 16th, the FOMC voted 12–0 to raise the federal funds rate a quarter-point to 3.75–4.00%, its first increase since 2023. The S&P 500 fell about 1% to a six-week low after the announcement.

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The AI Earnings Juggernaut — and the End of the “SaaSpocalypse”

The force that kept the averages afloat was, once again, AI-driven profits. In second-quarter earnings season, 86% of S&P 500 companies beat estimates and blended earnings growth reached about 50%, the strongest since 2021. The four largest hyperscalers are now guiding to $720–745 billion of capital spending this year, a number that has been rising steadily over the past few years. Technology fell about 3.5% in July on doubts about the payback, and software stocks got pummeled on fears of AI obsolescence, but that fear broke in late August on strong earnings results; as Salesforce CEO Marc Benioff put it, “This is not the SaaSpocalypse.” By September, technology was the only sector in positive territory, with semiconductors up more than 9%.

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Who Won and Who Lagged

The contrast with the second quarter could hardly be sharper. In Q2, nine of 11 sectors rose; in Q3, just four sectors finished higher — energy, information technology, health care, and communication services. Energy led on the back of $90 oil; technology and communication services rode the AI earnings wave; and health care, the earnings laggard of the first half, found buyers looking for shelter. Beyond that short list, leadership narrowed dramatically. The equal-weighted S&P 500, the Dow, and the Russell 2000 all closed the quarter at multi-month lows.

On the losing side, utilities, industrials, and real estate posted the steepest declines — a striking reversal for utilities and industrials, which had been darlings of the AI power and data-center build-out just a quarter earlier. Higher yields and questions about AI capex payback hit both sectors, though small caps were disproportionally punished, giving back a large share of their spring rally. Large-cap stocks fared better but also declined overall.

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Portfolio Positioning – Beware of Concentration Risk

Our approach to managing our portfolios remains unchanged. With an emphasis on risk, valuation, and a strong preference for quality and balance sheet strength, we focus on the long-term creation of value, rather than “playing” momentum. Hence, our strategy of identifying free cash flow generators with increasing earnings power is at the core of our investment process.

Consider how top-heavy the S&P 500 has become. Because the index is weighted by market value, a small group of the very largest companies, most of them tied to the same AI theme, now accounts for roughly 40% of its value, a degree of concentration not seen in modern market history. Buying the index today is a far larger bet on a single theme than many investors realize. This quarter showed the consequence: the index rose about 2% while the typical stock slid into a correction and the equal-weighted index closed at a multi-month low. Concentration works well on the way up, but it offers very little cushion if the leaders stumble, and with valuations on many of those companies in the top percentiles of history, we don’t believe it is prudent to let one theme dominate our clients’ portfolios simply because it dominates the index.

We come back to four questions for every company we own. Does it generate genuine free cash flow, the cash left over after funding its operations and investments? Is its earnings power growing? Is its balance sheet strong enough to weather higher rates and a slower economy? And are we paying a sensible price for all of it? With the 10-year Treasury above 5%, those questions matter more, not less. A business that funds its own growth from internal cash doesn’t need to borrow at today’s rates, and a reasonable entry price is the best protection we know of when the cost of money changes as quickly as it did this summer.

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Taking Action

Applying that discipline made for an active quarter. We took profits in three long-standing holdings, a consumer technology leader and two large discount and off-price retailers. Each has served our clients well, but their share prices had run well ahead of their earnings growth, leaving valuations that no longer offered the margin of safety we require. Trimming them locked in gains and protected capital without walking away from businesses we still respect. We also sold three positions outright, in insurance brokerage, sporting goods retail, and alternative asset management. Their near-term prospects were simply not as favorable as they were six months ago, and in a market that is punishing disappointment, we would rather redeploy that capital than wait for the picture to improve.

We put that capital to work where fundamentals are strengthening. The AI build-out is the largest corporate investment cycle in a generation, with the four largest hyperscalers alone guiding to more than $700 billion of spending this year, and we initiated two new positions to give the portfolio greater exposure to companies benefiting from that spending. We also added to our largest AI semiconductor holding, because its fundamentals continue to improve and its earnings growth has kept pace with, and arguably outrun, its share price. In each case, we are paying for earnings and cash flow that are already showing up, not for a story.

Finally, we strengthened the parts of the portfolio that do not depend on AI. We initiated a new position in a global mobility and delivery platform that has transformed itself into a substantial free cash flow generator and added to existing holdings in defense communications and electronics, medical technology, and paints and coatings. These are businesses with durable demand, pricing power, and healthy balance sheets, and they give the portfolio sources of growth that will not rise or fall with a single theme.

The result, we believe, is a portfolio better balanced than the index itself: meaningful participation in the AI growth story, anchored by companies with strong cash generation, sound balance sheets, and valuations we can defend. Momentum will have its seasons. Our job is to make sure your capital compounds through all of them.

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We look forward to communicating our thoughts to you in our next quarterly correspondence. As always, we appreciate your trust. For questions, please contact:

• Marshall Kaplan, mkaplan@ingalls.net  212-269-0264
• Rochelle Wagenheim, rwagenheim@ingalls.net  212-269-0265
• Michael Nelson, mnelson@ingalls.net  212-269-9785

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