Anxiety turns to hope as Wall Street stocks climb back to records

Anxiety has given way to hope on Wall Street.

Stocks are back near records, recovering from a slump spurred by fears that the excitement about the artificial-intelligence boom has outstripped the potential profits.

Optimism about AI has proved durable. But other important factors are also powering gains. Here’s a look at some of the reasons investors expect that the rally could go further from here:

Stock valuations could be worse

Stocks currently look very expensive by some measures, such as traditional price-to-earnings ratios. Still, even those ratios remain below their peaks reached in the 1990s dot-com boom. And stock valuations look less stretched in other ways.

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Many Wall Street analysts think the best way to value stocks is to compare their earnings yield—or earnings-to-price ratio, expressed as a percentage—with yields on ultrasafe government bonds. The additional yield shows how much investors are being compensated to hold the much riskier instrument.

One popular version of this metric, known as the “excess CAPE yield,” uses S&P 500 companies’ average earnings from the past 10 years and adjusts both those earnings and the 10-year Treasury yield for inflation.

As of November, it stood at 1.7%. That is low by historical standards—suggesting the high prices of stocks have shrunk the reward for owning them over bonds. But it is hardly unprecedented and actually up from 1.2% in January, thanks to a decline in the 10-year Treasury yield driven by a cooling labor market and the resumption of Federal Reserve interest-rate cuts.

Economic growth is supporting earnings

Ultimately, stocks are closely linked to the near-term outlook for consumer spending.

Right now, there are some concerns about the economy. Job growth has slowed significantly and the unemployment rate has ticked higher—enough to push the Fed to cut rates.

Attendees at the Albany Job Fair in Latham, New York, US, on Wednesday, Oct. 2, 2024.  (Angus Mordant/Bloomberg)

But investors and economists still aren’t that worried. Many believe that job growth has slowed largely because of sharply reduced immigration. Holiday spending is off to a robust start, and weekly unemployment claims remain stubbornly low.

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All of that should be good for companies’ bottom lines. Analysts expect 2026 to be another great year for tech companies in particular, even as they spend huge sums on AI infrastructure.

It isn’t just about big tech stocks

Tech companies including Nvidia, Microsoft and Meta Platforms have become such giant components of the S&P 500 that any doubts about the AI future will likely result in losses for not just tech stocks but also the entire index.

Still, the outsize gains for big tech companies don’t mean that other types of stocks are doing poorly. The Russell 2000 index of smaller company stocks reached a record high last week. The S&P 500 equal weight index—which gives the same influence to each company regardless of size—is also near a record, providing hope that a tech-centered selloff wouldn’t be disastrous.

“Massive tech behemoths are dominating the headlines and all the investment flows and analysis, but other companies are also executing,” said Michael Antonelli, a market strategist at Baird.

Inflation expectations are anchored

One lingering concern for investors is that inflation remains comfortably above the Fed’s 2% target, with the central bank’s preferred gauge sitting at 2.8% as of its most recent reading.

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Sticky inflation could make it harder for the Fed to keep cutting interest rates. If the Fed—potentially under greater sway from President Trump’s appointees—cuts rates anyway, investors could lose confidence in its commitment to stable prices, sending shock waves through markets.

Federal Reserve Chairman Jerome Powell. (Kent Nishimura/Getty Images)

Investors, though, are confident that inflation pressures are easing. Inflation expectations, after jumping earlier this decade, remain anchored. That can be seen in the spread between yields on nominal government bonds and those of Treasury inflation-protected securities, or TIPS—a gap known on Wall Street as the break-even inflation rate.

Prospects for longer-run economic growth have improved

Investors also have a big-picture reason to feel good. The economy, whatever it does over the next several months, looks to be in much healthier shape than it was for more than a decade following the 2008-09 financial crisis.

For years, the Fed kept short-term interest rates at zero—translating to negative real, or inflation-adjusted, rates—in an effort to jump-start moribund economic growth. Investors and economists fretted about a new era of “secular stagnation” that would hurt financially conservative savers and make it harder for the Fed to fight recessions.

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Negative yields on 10-year TIPS showed investors expected rates to stay at rock-bottom levels for the foreseeable future. Now, though, those yields have stabilized at precrisis levels. Analysts ascribe that partly to higher inflation and larger federal budget deficits but also to hopes for stronger economic growth—driven by private-sector investment in areas such as AI infrastructure and renewable energy.

“For a lot of investors, you have higher confidence to invest in general whether it’s equities or fixed income when real yields are positive,” said Thanos Bardas, senior portfolio manager and co-head of investment grade at Neuberger Berman. “It looks like the economy is operating at potential or above potential.”