Navigating 2026's K-Shaped Recovery: Rebalancing Amidst Labor Shortages and AI Risks

Key Quotes

"why is the market so strong when the economy is meh and i think part of the reason is because there are institutional things within our market things like um stock buybacks uh embedded capital gains uh money flowing into defined contribution plans all of this is funneling money into the equity market and it's hard to get it out because of you know capital gains tax and that's pushing money into giving us a really strong stock market in what's you know an okay economy but it's not nothing to write home about"

David Kelly explains that the stock market's strength, despite a mediocre economy, is driven by institutional factors. He highlights stock buybacks, embedded capital gains, and money flowing into defined contribution plans as mechanisms that funnel money into the equity market, making it difficult to exit due to capital gains taxes. This dynamic creates a strong stock market even when the broader economy is only "okay."

"but for investors the real thing is you know how much risk are you carrying because these are expensive stocks at this point and i think really the the resolution for 2026 is rebalance because you know whatever happens to returns the risk level is pretty high here"

David Kelly advises investors that the primary concern for 2026 should be the level of risk they are carrying. He points out that current stock valuations are high, indicating an elevated risk profile. Kelly suggests that rebalancing portfolios is the key resolution for 2026, regardless of potential returns, due to the significant risk level present in the market.

"i think that i think that i think there's a good chance it'll broaden out at some stage here but the other thing to think about is you know when you look at these mammoth companies who are pouring money into their version of ai they're all making the same bet and they've all got these sort of quasi monopolistic profits which are funneling into an enormous amount of spending on data centers and chips to be the ai superpower but they can't all be ai superpowers so even within the mag7 there's a lot of risk there that they're all chasing after uh a goal you know a brass ring that that not all of them can achieve and maybe none of them can achieve if you know china gets there first"

David Kelly discusses the potential for market broadening but also highlights significant risks within the "Mag 7" companies. He notes that these large companies are making similar bets on AI, leading to massive spending on infrastructure, but they cannot all achieve AI superpower status. Kelly warns that this concentrated pursuit of AI dominance creates substantial risk, as not all companies will succeed, and external factors like China's advancements could further complicate the landscape.

"i think that the first thing is is look at that ai trade and look at the some of the big players there is it going to come a point where people get skittish about some of the players in this space whether they will be the winners because if it looks like you're not going to be the winner then should you be putting all this money into it and if you shouldn't then you know how what's your business model looking like"

David Kelly suggests investors should closely examine the AI trade and its major players to identify potential vulnerabilities. He posits that investors may become hesitant about specific companies if it becomes clear they are not positioned to be winners in the AI space. Kelly emphasizes that if a company is unlikely to succeed, the rationale for investing heavily in it, and its underlying business model, should be questioned.

"i think that the the the three big themes that are going to drive through markets next year very much bond market focused number one cash is on the move if the fed is the fed is biased to ease then that 8 trillion in in money markets and in short term deposits are going to be looking for other places to go and in a world where inflation still remains up around that 3 level the the the free trade the easy trade is over you're going to need to move that cash into something else and so moving out into short duration bonds seem likely"

George Bory outlines three key themes for the bond market in the upcoming year, starting with the movement of cash. He explains that if the Federal Reserve eases monetary policy, the significant amount of cash held in money markets and short-term deposits will seek other investment avenues. Bory notes that with inflation remaining around 3%, the "easy trade" is over, necessitating a move into other assets, with short-duration bonds being a likely destination.

"the second is the curve the curve itself kind of came down a little bit yields came down a little bit this year sounds as if we're going to see more of a twist next year that front end coming down the long end could actually start going up again and so we think that that actually is a really big theme that bond investors are going to be contending with"

George Bory identifies the yield curve as the second major theme for bond investors. He observes that while yields decreased somewhat this year, the expectation for the next year is a "twist" in the curve. Bory anticipates the front end of the curve to decline while the long end may increase, presenting a significant challenge and area of focus for bond investors.

"and then the last you talk about halves and have nots if we look at the uh the corporate side of the economy you know event risk defaults m a the ai build out the drawdown of cash in the system to sort of spend money on things has kind of a mixed impact on credit markets and credit markets themselves are seeing a pretty big kind of increase in dispersion and would suggest that we're in the later stages of a credit cycle not the end but very much the later phase"

George Bory discusses the third theme, focusing on the corporate economy and its impact on credit markets. He points to event risk, defaults, mergers and acquisitions, and the AI build-out as factors contributing to a mixed impact on credit. Bory notes a significant increase in dispersion within credit markets, indicating that the economy is in the later stages of a credit cycle, though not yet at its end.

"i think if you look at the s p it's sort of like a a holding company with two divisions in it one of which the big tech monsters and then the everything else at a very simplistic level so you can look at the spx equal weight uh a proxy for everything but the mag 7 and if you look at that earnings growth year over year is sort of 4 uh can it beat that well it will need to a have some decent nominal gdp to go along with that that i think i expect i think the harder one is whether the margins will really be there to support uh support that embedded in that 4 earnings growth"

Michael Purves characterizes the S&P 500 as having two distinct divisions: big tech and "everything else." He uses the S&P 500 equal weight index as a proxy for the latter, noting that its year-over-year earnings growth is around 4%. Purves questions whether this growth can be surpassed, suggesting it would require decent nominal GDP and, more critically, sustained profit margins to support the