SUMMARY
Despite recent market volatility, resilient fundamentals offer tactical strategies for high-quality assets. Diversified AI exposure is among the potential opportunities we see.
KEY TAKEAWAYS:
Market volatility and drawdowns are potential dip-buying opportunities, given stable fundamentals
With fundamentals diverging, diversifying may be best concentrated in weaker and unprofitable segments where stretched valuations leave limited downside protection
Brazil may offer a compelling, non-U.S. way to capture the AI buildout through commodities and rare earth exposure
Despite volatile price action, there is little evidence of fundamental concerns.
For a significant drawdown to occur, fundamentals must weaken – something we haven't seen in the data yet.
Since 1990, the S&P 500 has experienced 29 drawdowns greater than 10% over a six-month period. In 80% of those instances, these drawdowns were in anticipation of a deterioration in fundamentals, where earnings per share (EPS) over the next 12 months also dropped into negative growth territory over a six-month period.1
The valuation component of price is more volatile than the earnings component, and earnings drive valuations over time. Simply put, when companies continue to deliver growth, temporary valuation dips present opportunities to buy.
We view the recent drawdown in the market through this lens. There are several factors driving market headline risk right now – the (hopefully ending) U.S. government shutdown, persistent inflation and impacts on lower income consumers, and the AI bubble narrative, to which we do not subscribe.
Meanwhile, Q3 earnings season is on track for double digit year-over-year growth and the ratio of upgrades to downgrades for 2026 earnings gained momentum over the last week. In fact, earnings growth is currently expected to reaccelerate in 2026.
With resilient fundamentals as a support for the market, we view persistent, headline-driven volatility as a potential buying opportunity for high-quality, long-term capital.
When should there be more caution in buying a dip? The most prevalent times to be cautious are when earnings growth falls by more than 10%, as prices typically fall by 20% or more in those instances. These moves are bear market corrections that occur around recessions or risk thereof. In fact, the only instances of S&P 500 forward 12-month EPS declining 10% or more since 1990 happened during three of the last four recessions – Tech Bubble, Global Financial Crisis, and COVID.2
Bottom line: Current market volatility is a potential opportunity to add quality exposure. Fundamental strength still underpins the market despite elevated valuations. Until a significant deterioration in fundamentals occurs, we believe headline-driven pullbacks in the market may present tactical buying opportunities.
Hedging risk is more appropriate in assets with less fundamental support.
Expectations for dovish U.S. monetary policy in the face of resilient real GDP growth (Atlanta Fed GDP Now at 4%) opened the playbook for investors to chase assets with less fundamental support over the last few months.
We include small caps and unprofitable technology companies in that category. On a 120-day rolling return basis over the last ten years, the latter outperformed by more than two standard deviations in October, rivaling post-COVID moves. Yet, these companies still post negative net margins (-3.4%), compared with +12% for the S&P 500. While the S&P 500 also trades in the top decile of valuations across most metrics, we see more credibility in adding exposure to an index with record margins and double-digit earnings growth and hedging exposure to one with negative profits.
We challenge the view that above trend real growth and above target inflation can be met with the easy monetary policy investors currently expect. In other words, we view the four additional rate cuts priced in for 2026 as too aggressive. The Fed will either continue cutting to support a weakened economy or will pause in the first half of 2026 to restrict further inflation. Either way, we expect some disappointment for rate-sensitive, higher beta exposures as the Fed grapples with its diverging dual mandate, putting a floor in for perpetually easier financial conditions.
Bottom line: Overextended, low-quality segments where price action does not coincide with fundamentals are consistent with our view that risk management should focus on weaker and unprofitable areas of the market.
Outside the U.S., we see opportunity in AI diversification.
Through our four-pillar framework – regime, fundamentals, flows, and valuation – we see the potential for compelling opportunities in Brazilian equities.
Brazil may offer a way to capture the AI buildout with a commodity kicker. The country holds the world’s second-largest rare earth reserves after China, and its equity market remains heavily weighted towards commodities. Fundamentally, earnings revisions are trending higher, while a 10% real policy rate anchored by a hawkish central bank supports the currency.
Year-to-date, the Brazilian Real has recovered roughly half of the losses it experienced between mid-2023 through year-end 2024, helped by a shift toward policy orthodoxy following the exit of Central Bank Governor Roberto Campos Neto at year-end 2024. ETF flows have recovered after years of outflows but are not extended. Investor sentiment is subdued, while the economy enters a benign reflationary phase in a regime historically supportive of equity gains. If global inflation stays firm, Brazil’s commodity exposure positions its equities to outperform.
Bottom line: While we remain optimistic regarding the progression of the U.S. AI narrative, there may be opportunities to diversify exposure geographically to this theme. Brazil may offer a less expensive entry point to a market exposed to the AI supply chain via commodity-linked sectors.
