Earnings strength supports U.S. stocks amid a leadership rotation

The U.S. equity market has begun the year with improving breadth and continued earnings resilience. What started as a narrow rally led by mega-cap growth stocks has evolved into a broader advance, with increased participation from cyclical areas of the market, value stocks, and smaller companies.

At the same time, historic levels of capital investment and the growing sense that AI will disrupt software and knowledge-based businesses has pressured performance in areas of the market that have been sources of strength until recently. Taken together, the result is a market that’s undergoing a rebalancing, which we generally consider a structurally healthy development.

Notwithstanding geopolitical developments, which can pressure stocks, economic growth prior to the start of the Iran conflict has been tracking a solid path with stimulus for consumers and businesses through the OBBBA tax cuts, deregulation and government spending.

Unless geopolitical risks escalate beyond the Middle East, worries about a spike in energy prices may be premature, and we are coming out of a period of relatively low energy prices. Many oil and natural gas producers have been operating under self-restraint, and sanctioned countries have still been finding ways to deliver oil to market. In other words, there is spare capacity to come online in response to higher prices, though we acknowledge the short-term challenges.

Market breadth improves as leadership rotates

By the numbers, the S&P 500 is essentially flat year to date through mid-February despite five sectors being up by more than 10%. Leading sectors include a mix of cyclicals—energy, materials and industrials—and defensives—consumer staples and utilities.

Small-cap stocks have rallied this year, with value handily outperforming growth as investors bet on a cyclical recovery. Investors have also picked up on the valuation discount that existed in profitable companies which we identified as an opportunity late last year. Profitability has been increasingly rewarded in small caps as the S&P 600 (which has a positive earnings requirement) overtook the Russell 2000 (in which about 40% of companies are unprofitable) at the end of January and has expanded its lead since then.

Overseas, international equities have retained momentum in early 2026, with emerging markets leading international developed markets and both outperforming the S&P 500, reinforcing the global nature of broadening leadership.

Most of these cases show that investors are reallocating toward economically sensitive and previously underperforming market segments as confidence in durable growth and a less-restrictive interest rate environment comes into focus.

More recently, equities have exhibited a defensive tone in the lead-up to the Iran conflict and in its immediate aftermath. Should these geopolitical events expand to other areas or the duration of risks persist, the rotation to cyclicals may pause if consumer confidence weakens or inflation increases with a sustained spike in energy prices.

Earnings remain the anchor

With earnings season largely in the rear-view mirror, the S&P 500 looks set to deliver the fifth straight quarter of double-digit year-over-year earnings growth to conclude 2025. Information technology, which has been a long-time fixture of earnings leadership, was joined by the industrials sector in fourth-quarter 2025 to lead in terms of reported earnings growth and positive earnings surprises.

Stock price reactions were notably mixed for the mega-cap tech stocks, which may be attributable to their record-shattering capital investment plans. Just four hyperscalers announced $600 billion in capex for 2026, representing a roughly 70% increase over their 2025 outlays. Capex diverts cash flows away from stock buybacks and dividends, which offer more immediate benefits to shareholders, and toward investments with longer-term and uncertain payoffs.

Exhibit 1: Hyperscaler capex soars

2026 capex based on estimates. Source: Bloomberg. Any mention of specific companies in this material is for informational purposes only and does not constitute an endorsement or recommendation.

Wide range of valuations still evident across the market

The S&P 500’s 12-month forward price-to-earnings (PE) ratio remains about 22x, which is in the 94th percentile relative to its history and so quite elevated. Still, durable earnings growth has helped keep U.S. equity valuations in check over the last year even as the market continued to make all-time highs.

The rally in small caps has had a mixed impact on valuations. The Russell 2000 now trades at 29x forward earnings which, like the S&P 500, is in the 94th percentile versus its history dating back to 1995. Meanwhile, the S&P 600 only trades at 16x earnings given its emphasis on positive earnings.

We are pleased to see positive performance broadening across small caps, but elevated valuations—particularly among companies with poorer earnings track records—reinforce the need for selectivity rather than indiscriminate allocation.

AI, software, and capex

Software stocks have been in the headlines in recent weeks after leading significant selloffs that affected several different types of knowledge-based businesses. Concerns about how advancements in agentic AI could impact their growth and historically attractive profit margins pushed software stocks 15% lower in early February, and they’re down about 30% from last September’s highs.

Software companies now trade at a forward PE multiple of approximately 17x, well below their recent 2021 high of 46x, as investors have re-rated the industry’s prospects. Their share of the U.S. equity market has also declined.

In our view, this is a healthy market dynamic for investors to question the return on investments and not blindly reward stocks for spending. Many unprofitable, highly levered, richly valued tech companies rightfully should have their valuations ratcheted down.

On the other hand, many high-quality software and asset-light businesses have been unfairly sold down with the group. Many cash-flow-rich software technology companies will continue to innovate and incorporate agentic tools into their businesses to drive growth. We believe this market shake-out will eventually filter out the weak, and the strong companies will recover in value.

Exhibit 2: Software weight in S&P 500 has fallen fast

Source: Factset

At the same time, despite the historic levels of 2026 capex guidance from the largest hyperscalers, their profit margins continue to expand. They’re not necessarily being rewarded for their high degree of investment right now, but they’re generally still seen as AI platform and infrastructure leaders rather than disruption targets, hence their ability to continue commanding premium valuations.

Stay selective amid broadening participation

The combination of sustained double-digit earnings growth and improving market breadth provides a positive backdrop for U.S. equities. However, in our view, valuation discipline is growing increasingly important as leadership rotates and newfound sensitivity to capital investment could mean market returns will align more with corporate fundamentals.

Today, cyclical sectors are contributing meaningfully to earnings growth while trading at comparatively modest PE ratios. They’re expected to continue benefiting from industrial activity, infrastructure buildout, and durable economic growth, all supported by declining interest rates.

As a result of these dynamics, we see appealing opportunities in quality cyclical companies, prefer selective exposure within technology, and believe valuation discipline will make a meaningful difference across market capitalizations.