The times they are a changin’
The promise of artificial intelligence has been part of our collective imagination since I took (and nearly failed) a class on AI at Stuyvesant High School in 1983. The advances in computing power and technology since then have been nothing short of stunning, and if you are too young to remember those early days there are plenty of ways to look back just to see how far we have come.
The next AI frontier, which has been the subject of much analysis and spending, with the promise of much more of both to come, has been likened to the industrial revolution as well as the vast changes created by the internet. Whether this is hype or promise remains to be seen, but it will most certainly create change and uncertainty.
While AI in many forms is not new, the incorporation of large language models and the ability to ask complex questions sparked the imagination of users as well as investors, and spending continues to rocket higher as the major technology companies look to stake out territory in an AI “land grab”. For markets, this is not a new phenomenon, as it has been the growth story for US equity markets for the past couple of years. What is new, however, is a wider background discussion of what types of returns can be expected from these major investments.
The high cash on cash returns of the major technology companies, combined with zero interest rate policies post the financial crisis over the last decade and a half, ushered in a new investing paradigm where larger technology and communication stocks dominated the landscape. While there have been short periods of time when those groups underperformed, for the most part the dominance has been sticky, and rightly so given the amazing financial results and returns on investment these (mostly US) firms have been able to post year after year.
This lengthy discussion is the introduction to the “now what” question investors and markets are seeking as we go into the latter half of the 2020’s. The answer is critical as the size and scope of the dominant technology players is enormous, and most market benchmarks are beholden to the performance of a select few, be they FAANG, the “Magnificent 7” or whatever term is next created to describe them.
While there are obviously many more global, political and financial questions than simply where goeth AI, for US equity markets in particular it is still a very important question. As we head into 2026, the evidence for and against some of the biggest hopes and dreams of equity investors may start to see some answers — and therein lie the opportunities and the potential pitfalls.
The shift from “asset light” to “asset heavy” carries significant investment repercussions, and as we exit 2025, a key question is how the market adapts to this transition. Companies that have dominated the technology space have been cash generators and they are now moving to spend huge amounts of that cash, in many cases borrowing money to do so. This is a paradigm shift from a corporate standpoint, and it is happening with equity valuations at fairly high levels, so continued belief in a positive outcome is critical.
Low-to-zero interest rates and a high cash conversion is an easier model to justify premium valuations than high cash usage and an argument over whether US interest rates are too restrictive or not. A new President in the White House with a very different view on global trade, highly indebted governments globally and a world economy still trying to shake off the economic and political effects of a pandemic that realigned supply chains all have their own investment ramifications. A White House arguing in public with the US Federal Reserve adds to the policy uncertainty, just as global indebtedness hamstrings governments that want to continue to spend more money than they have.
The Federal Reserve rate cut on December 10th was well anticipated, although the path ahead is less clear given dissenting views on the Board. The monetary policy narrative will continue to be an important theme into 2026 as global central banks are still dealing with levels of inflation that are above target.
We believe that the beginning of next year may start with a more sober outlook as most post New Year’s celebrations do, and a more serious assessment of the risks and potential rewards as investors focus on the year ahead.
From our vantage point the most critical issue of 2026 will be earnings, specifically earnings growth and margins. Consensus currently sees S&P 500 earnings growth of somewhere between 13–15%. Year to date the earnings growth has been over 12%, although estimates for the fourth quarter may bring the full year growth rate for 2025 to just over 10%. As has been the case for the last several years, the bulk of that growth will be coming from the technology and communications sectors. The “catch up” trade for the rest of the market has been long heralded, and there is some expectation that the other sectors of the market may start to benefit from some of the productivity promises of AI.
There will be keen attention paid to how that expectation is manifesting, as the flip side of productivity is very often job losses, and we already see signs that the labor market is having some issues and may be weaker than advertised. The lack of government data does not help that concern, although prior to its suspension there were questions about the data itself with revisions sharply curtailing job growth numbers before the shutdown.
Equity markets have benefited from a rise in earnings as well as an easing cycle by the Federal Reserve. Can the earnings growth continue even as capital spending continues to rise? What happens to margins as expenses go higher from a group of mega technology companies that have long been cash rich? Current spending estimates look to be manageable within the balance sheets of the major spenders, but not all balance sheets are created equal, and we suspect that there will be a laser-like focus on financing in 2026.
There are several major risks that we see on the horizon. Any upsets in the AI spending juggernaut have been followed by equity market weakness, and we expect that to continue, although most of these have been short lived in the recent past. There are concerns about the private credit market, and the CEO of JPMorgan pointing these out in colorful language also caused some investor trepidation. The IPO market has remained tepid at best, which has caused some private equity firms to engage in creative ways to monetize prior investments, some of which have not fared well recently.
Social tensions are on the rise as affordability remains a major issue, both in the US and globally. Structural changes to the housing market post the financial crisis as well as a reluctance by homeowners to swap a low-rate mortgage for a high-rate one have been a serious problem for those looking to buy a house. Stock market gains, while great for investors, do not mitigate price level changes that consumers are still dealing with post the pandemic — and it is unlikely with the amount of global liquidity put in the system by global banks that this problem will get better. Even if inflation slows further, which is not a given, it will not bring price levels down, and that is hurting consumers worldwide.
There is always concern when markets are at historically high valuations, although rarely is it equity valuations that cause problems. Generally financial markets are more concerned with problems in the credit markets and here you can take your pick between private credit, government indebtedness and state and local budgetary needs. There have been rumblings in Japanese debt markets recently and swings in currencies can also act as the proverbial butterfly flapping its wings.
There are counter arguments about valuation, as it is the larger tech firms dominating the space, and it could be said that the rest of the market, if bifurcated, does not look as expensive. The earnings downtrend in US small-cap stocks, originally expected to reverse in 2025, is now projected to turn in 2026 — a shift that could ultimately benefit US equity markets. Fiscal policy as well could be a positive, although we may again be flying close to the sun with US budgetary issues still looming.
The spend for new technology also includes many companies that would not typically be considered technology companies, as the need for additional power grid resources and ancillary services for all of the data centers requires capital spending beyond the GPUs Nvidia is selling to the world.
We are cautiously optimistic that absent any major financial hiccups in the more esoteric financial corners of the world, the great AI capital expenditure wave will continue to rise, taking many other players up as well. The law of large numbers would suggest that the rate of growth will have to slow at some point, and how investors react to that will depend in large part on what new promises and use cases emerge for the technology that everyone is so entranced by.
We are already seeing a shift on the part of investors to an emphasis on the potential beneficiaries of the new AI technology. This comes with both opportunities and costs, the costs being not only financial, but also in potential job losses due to efficiency and the greater capabilities of current AI to handle some tasks. A good example of this has been the move by fast casual chains to automate order entry and decrease the number of employees in stores. While AI is heralded as an opportunity for better productivity, the dark side of that is a declining need for workers, especially at entry level jobs that are often the start of many careers.
We see the benefits of the combination of lower interest rates and greater efficiency starting to accrue to mid-cap and small-cap companies as we move into 2026. While we expect the technology sector will continue to grow, we see a broader investment opportunity set elsewhere. Driven by the expansion of tech use cases into new industries - and less burdensome valuations outside of pure tech — the scope for investment is widening. With interest rates falling and inflation moderating, we favor strategies that prioritize income and returning capital to shareholders through dividend growth and repurchases.
As always, we will continue to favor high quality companies with good balance sheets and cash flow, as well as innovators that can take advantage of new markets and paradigms all with an emphasis on quality of management and strong underlying fundamentals. The landscape will continue to shift as AI becomes more ubiquitous and we will be looking to take advantage of those shifts.
The views expressed are those of the Alpine Saxon Woods, LLC management team as of the date indicated, and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Performance data quoted represents past performance and does not guarantee future results. All data referenced are from sources deemed to be reliable but cannot be guaranteed. Investors seeking financial advice regarding the appropriateness of investing in any securities or investment strategies should consult their financial professional.
