The biggest driver of volatility in the stock market this year has been from the ongoing war in the Gulf Region.  There has basically been a binary reaction in the markets as the expectations about the outcome of the war shifts.  When the conflict began at the end of February and fears rose about a continuation or resumption of bombings, we saw a rise in oil and the U.S. dollar and an offsetting fall in almost all risk assets, including stocks, gold and bonds.  But over the last two months we have seen the reverse of that scenario as investors have been buying into the Trump proclamation that the war will end soon, that they have agreements pending on removing the ‘enriched uranium’ stockpiles and fully re-opening the Strait of Hormuz, after which oil prices will retreat back to pre-war levels.  While we may see the ‘outline’ of an agreement that could send risk markets even higher, the reality is that the physical oil market is still tightening and will soon hit critical levels.   Moreover, Iran probably feels more empowered over what has occurred in the Strait and is less likely to give up their uranium stockpiles.  ‘Kicking the can down the road’ in terms of a real agreement will only give temporary reprieve to markets.  Our strategy were this scenario to unfold would be to sell stocks into any further strength and then add to oil stocks on the expected weakness that they would see.  It took over eight years for the U.S. to get out or Iraq after the initial invasion in 2003.  It seems unlikely to us that the situation in Iran will go back to pre-war status anytime soon!  Even if oil prices retreat back to the US$75-80 level, the Canadian oil producers would still remain immensely profitable and would be able to continue buying back their stocks and/or increasing dividends.

But the prospect of an end to the hostilities in the Persian Gulf region have only been partially responsible for the recovery in the stock market over the past two months.  The first quarter earnings reports from the corporate sector, especially from those companies involved in the rollout of data centres and associated investments, have been exceptionally strong and made investors downplay the risks to oil prices, inflation and the path of interest rates and keep buying stocks.  This trend continued in May, with tech stocks clearly back in the leadership position.  The S&P500 rallied another 5% in May to push the year-to-date gains to over 15%.  The tech heavy Nasdaq Index was the leader, gaining over 8% on exceptional strength in the semi-conductor stocks, which pushed the 2026 gains to over 24%.  In a reverse from last year, the Canadian stock market has been lagging those U.S. gains, held back by weakness in the precious metals sectors as well as technology which, in Canada, is dominated by software stocks such as Shopify and Constellation Software.  The TSX Index added almost 2% in May, pushing its year-to-date rise to over 9%, with the Energy sector being the biggest contributor to those gains, rising over 37% so far in 2026. 

The bigger question going forward is whether these gains are sustainable.  Clearly the ultimate outcome of the conflict in the Gulf will be the biggest determinant of the next move in stocks, particularly since the physical oil market is quickly moving toward a ‘choke point’ as inventories have been run down and new supplies continue to be restricted by the blockade in the Strait of Hormuz.  Without an agreement to re-open the Strait, the price of oil is most likely headed back up over US$100 before the full summer driving season.  While we have no doubt that the tsunami of major tech spending will continue, which will benefit the semi-conductor companies and others involved in the data centre build out, investors are clearly starting to put a bigger emphasis on the monetization of this spending.  The degree to which these tech companies can demonstrate a profitable outcome from either increased revenues or reduced cost will determine the direction of stocks.  The stakes could not be higher though, with investor sentiment and market positioning running at record levels.  To quantify those risks, are we being too old-fashioned to talk about such mundane things as long-term valuations and deviations from mean values?  The chart below shows a composite of four well known long-term valuation metrics for stocks.  At the end of April, the average premium of those four relative to their long-term means is 152%, one of the highest levels in history. For an eleventh straight month, the average is more than 3 standard deviations above its historical mean, signalling a substantially overvalued stock market.  As can be seen, the current level recently surpassed the peak in 2021, during the ‘meme stock’ frenzy and the pandemic government spending surge.  We are far, far beyond prior peaks such as the ‘tech bubble’ in 2000, the ‘Nifty Fifty’ surge in the 1960s and even the almost century-old peak prior to the Great Depression.  Not suggesting that this is a good reason to sell all your stocks and go to cash, but it is illuminating to understand what some of the downside could be if the bullishness around this tech optimism starts to unwind! 

Arithmetic Average of Valuation Indicators (Crestmont P/E, P/E10, Q Ratio, Regression to Trend)

The values above are all related to the valuation of the stock market relative to long-term earnings or the economy itself (the Q-ratio).  Other traditional measures are also at all-time highs.  On average, the stocks in the S&P500 are selling for an average 3.65 times their underlying revenue. That is double the 30-year average of 1.81.  The only way to justify this lofty price-to-sales multiple is to assume that companies are going to start extracting much higher profits from every dollar of their sales. But they already are.  Corporate profits as a share of the overall U.S. economy are sitting at record highs.  Optimism about profit growth has been the cornerstone of the most recent rise in stocks so it is noteworthy that these profit margins are already at record levels.  Either AI is going to be truly transformational compared to any other industrial revolution in history, or the stock market is ‘way ahead of itself.’  Investors need to remember the difference between growing companies and rising stock prices.  Microsoft hit a ‘bubble peak’ in 2000 that took 15 years to reach again, despite showing earnings growth throughout that entire 15-year period.  For switch manufacturer Cisco Systems, which was the highest valued company in the S&P500 at one point in 1999, it took 25 years for the stock to return to that level!

Dare we question the reality of the ultimate impact of AI versus the short-term enthusiasm.   The four largest cloud providers (Amazon, Alphabet, Microsoft and Meta) are on track to spend almost US$700 billion on AI-related capex in 2026, up from around US$430 billion last year.  How are returns from these massive investments doing so far?  Microsoft’s Copilot, designed to monetize AI across more than 450 million commercial Microsoft 365 licences, had converted only about 3.3% of that base to paid subscriptions by early 2026.  A 2025 S&P Global survey found that 42% of organizations had scrapped most of their AI initiatives, with ‘AI proof-of-concepts’ frequently killed before going live. Analyses from RAND and others put enterprise AI implementation failure rates in the 70-85% range, far above typical IT projects. Goldman Sachs still finds no meaningful relationship between AI adoption and economy-wide productivity, despite sizable gains in targeted use cases. Deutsche Bank points out that the market is valuing AI companies at levels rarely seen in history despite their large losses and uncertain path to profitability. The spending is real. The associated returns, at scale, have not yet arrived.  Bullish investors also believe that the AI boom will spill over into other industries, helping to boost share prices across multiple sectors.  Microsoft, Meta, Alphabet and Amazon have forecast combined spending just shy of $1.5 trillion on capital expenditures over the next two years. That is income for the construction companies, air-conditioning outfitters, roofers, chipmakers and so on surrounding the AI infrastructure build-out, boosting demand for their services and pushing those share prices higher.  The more immediate impact of this massive spending has been upward pressure on core inflation measures which have reduced the prior expectation that central banks will be cutting interest rates anytime soon.  For 2025 numbers, the AI cycle has already surpassed the dot-com era in its contribution to growth, and its contribution is rising this year.  Across the first three quarters of 2025, AI-related categories accounted for 39% of total GDP growth, compared with 28% during 2000, the height of the dot-com investment boom. Software has been the key differentiator, contributing far more to today’s cycle than it did twenty-five years ago.

Scarcity has been one of the hidden supports behind the buy-the-dip, and increasingly buy-the-high, stock market. The market is buoyed by sharp rallies in a narrow group of industries and stocks. It also triggers the meme-like swarming interest in certain names that we have seen in the memory chip market and space stocks.  The supply of public equities has been shrinking for years because of corporate buybacks, so that we have been in a period of increased demand for stocks and shrinking supply.  I learned in my very first economics class that reduced supply and increased demand leads to higher prices!  One change to that regime could be coming from the supply side of stocks.  For the last number of years there has been a tendency for the big technology companies to absorb many of the green shoots in the economy before they mature into large public companies.  Think of Alphabet buying YouTube years ago or Meta buying WhatsApp.  But a wave of mega-IPOs could change much of that trend.  Major private companies such as OpenAI, Anthropic, and SpaceX could collectively come to market with valuations approaching $4 trillion, equivalent to roughly 6% of the U.S. public equity market. Not all that value will float immediately, but it would still represent a major boost to equity supply in the U.S. market. History suggests that major IPO waves often arrive late in bull markets, when valuations are high, investor enthusiasm is strong, and insiders are more willing to sell. Fresh AI listings could absorb capital that has been flowing into the current winners, alter index weights, and force a rebalance away from the existing incumbents.

While stocks have rallied sharply from their lows, the bond market continues to struggle, providing only tepid returns.  Investors are discovering what long-term government borrowing costs are really like when you remove the potential backstop of central bank intervention from the bond market.  The main driver ‌of surging U.S. long-bond borrowing rates this year is clear enough: the Iran war, the related oil shock, racing inflation and the inevitable speculation about interest-rate rises.  Thirty-year Treasury yields have risen more than 50 basis points since the war began, topping 5.1% for the first time since before the Global Financial Crisis in 2007. Ditto in Canada where, despite ongoing trade risks and slower growth, 30-year bond yields topped 4% for the first time since 2010.  But that milestone also reflects another factor that’s aggravating the ⁠sudden repricing of the debt market. Bonds have not traded without either actual central bank buying or the implicit threat of it in a shock since 2007.  That leaves the very long end of the market without the effective safety net it’s enjoyed for 18 years since the Fed first launched quantitative easing (QE) after the 2008 banking crash. Now enter Kevin Warsh as the new Federal Reserve chair.  Warsh is a longstanding public opponent of Fed bond-buying and a staunch advocate of running down the central bank’s $6.7 trillion balance sheet of mostly Treasury securities.  But he is also viewed as being an acolyte of the U.S. president and will be under tremendous pressure to try to drive short term interest rates lower but will have a hard time convincing the other eleven voting members of the Federal Reserve to vote for those rate cuts.  His first meeting as the new head of the Federal Reserve on June 16-17 could be one of the more interesting ones we have seen in quite a while.

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