Market at an Inflection Point
The market looks like a beach ball held underwater. When that ball is let go, prices explode higher. Indices sit at or near all-time highs, a point or two below the record. Under the surface the picture is worse. Five or 10 AI stocks are holding the indices up. Since rates started rising and the Iran situation began, the thinking is that if a slowdown comes, AI is the only thing that could still work.
About 95% of the market tells a different story. 53% of the S&P 500 components trade below their 200-day moving average. 73% of components trade below their 50-day moving average. These are extremes last seen in 2007 and 2000. Either the 95% catches up and shows some health and breadth, or the five or 10 leaders catch down to the rest. Negative beta is the highest since March 2000 - meaning these stocks move opposite to the indices. Many crosscurrents are running as yields spike.
What Precedes Corrections
Every major stock market correction has been preceded by one of three things: a hiking cycle, a spike in yields, or a spike in oil prices. We may have all three now. It is not confirmed yet whether this is a hiking cycle - there was one hike. Yields are spiking. Oil is elevated.
Rates keep rising and sit 30 basis points from an inversion. There is a 70% chance of a hike at the Fed meeting on October 28th. A hike into a short-term supply shock would be a second mistake, and with only 30 basis points to play with, the two-year and 10-year would invert. An inversion brings a recession - that is the bad news. The good news: the market tends to rally for the next 6 to 12 months after an inversion, before the recession hits.
Politics and Iran
President Trump has to notice the political shift. Before the Iran war, Republicans had an 80% chance to sweep the House and Senate. Now Democrats have a 63% chance to sweep both. That leaves everyone walking on eggshells. Trump is holding out for a better deal while rates spike.
The war with Iran has lasted far longer than expected, including by the Trump administration, which said it would be short. This week marks the seventh month. Progress seemed to come around the UN General Assembly, with talk of de-escalation, but there is no resolution. Trump rejected the offer because Iran's demands were still too high. He thinks he has leverage and is bleeding them out. Iran's economics are shifting, and meaningful barrels are moving through the strait under supervision. Brent is around $107 a barrel; WTI is closer to $96.
Buy Defensives and Treasuries
Defensive stocks that should do well in these periods - healthcare, staples, and now Treasury bonds - are the most out of favor relative to the S&P 500 since March 2000. That is when you want to buy them, when they are completely out of favor. The last comparable case was energy in 2000. During COVID, when the world shut down, energy fell to 2.5% of the S&P 500, oil went negative, and people said no one would ever buy Exxon Mobil (XOM) because pensions could not own it over ESG issues. Exxon was bought heavily at $33.
The situation now is similar. A buyer of the 10-year Treasury note makes sense at a 5.20% yield; even at 5% you lock in 5%. The stock market offers a 5% earnings yield with no guarantee. Buy healthcare and defensives selectively for ballast, rather than staying concentrated in AI names that have run up and are priced for perfection. Another 5x in Intel (INTC) or 10x in some semiconductor stocks over the next 12 to 24 months is unlikely - those stocks probably have to consolidate gains or pull back. Defensives should serve well into the election, when volatility could pick up.
PayPal (PYPL): A Turnaround
The Stripe deal that broke down was a lowball offer and a joke, so it does not change the case. The stock is down 80% from its 2021 highs, while price value, earnings, and revenues are all up 50% since that $300-plus peak. Free cash flow runs over $6 billion a year, up 27%. The company is buying in 15% of itself and has already bought back close to 30% of shares.
Margins compressed, but the business did not get worse. The lower-margin Braintree unit - which processes payments for Uber (UBER), Ticketmaster, and similar - grew faster than the branded checkout, the PayPal button people know. Cash flow per share, revenue per share, and earnings per share all rose even as margins fell. Margins are now reaccelerating. The company is rebuilding branded checkout with Fastlane, which improves merchant conversion by 51%, letting PayPal charge more because it makes merchants more money.
PayPal (PYPL) leads in agentic commerce. It signed a deal with Meta's (META) Muse and has agentic tie-ins with Copilot and ChatGPT, so chatting on any large language model likely means paying with PayPal. A buyout is possible through the Meta partnership, and PayPal's ad business is very valuable and just starting. Mark Grether, who built the Amazon (AMZN) ad business and the Uber ad business, now runs it at PayPal, which could add $1.5 billion to $2 billion of free cash flow and further reaccelerate margins. PayPal trades at nine times earnings.
Disney (DIS)
Streaming is doing well. Disney (DIS) trades at 13.9 times earnings versus a 5-year average above 20 times. The new CEO ran the experiences division. All divisions are growing close to double digits. Experiences include 12 cruise ships, 57 hotels, and 12 parks, all humming. Streaming has 195 million subscribers, second only to Netflix (NFLX), and is now profitable with $700 million in operating income, after predictions it would lose money forever.
Streaming is bundled with ESPN, the number one sports franchise, which will show the Super Bowl this year with ads already sold out. A park is opening in Abu Dhabi. Cruise ships deliver the highest return on invested capital; two more are being added this year, booked years in advance. Over the past 50-plus years, Disney (DIS) consolidates sideways for 8 years, then goes straight up for another 5 years. The company generates $10 billion a year in free cash flow and will keep buying back stock.
