A Strong Index Masks a Weakening Market
The third quarter of 2026 demonstrated once again that the headline performance of an equity index can conceal substantial differences beneath the surface. The U.S. economy continued to expand at a solid pace, while corporate earnings remained resilient and artificial-intelligence investment continued to support economic activity. At the same time, rising energy prices, higher Treasury yields, persistent inflation, and renewed geopolitical uncertainty created a markedly more difficult environment for many investors.
For the quarter, the S&P 500 gained approximately 2.3%, while the technology-heavy Nasdaq Composite gained approximately 2.6%. By contrast, the Dow Jones Industrial Average declined approximately 2.3%, and the Russell 2000 fell approximately 7.2%. The divergence between large-cap technology and the broader market was particularly notable. The market’s resilience therefore needs to be viewed with some caution: the capitalization-weighted S&P 500 remained near record levels even as weakness spread across a large portion of its constituents.
Perhaps the most striking statistic was market breadth. By the end of September, approximately 59% of the companies in the S&P 500 were at least 20% below their respective highs—a conventional definition of a bear market. More than 70% were at least 10% below recent highs. The result is an unusual market in which the index itself remains relatively strong while a majority of the individual companies underneath it have already experienced bear-market declines. This divergence is a reminder of the extraordinary influence that the largest companies now have on the capitalization-weighted index.
The bond market presented a very different picture. Longer-term Treasury yields rose sharply during the quarter, with the ten-year Treasury moving above 5% and reaching levels not seen since before the financial crisis. The rise in yields reflected a combination of persistent inflation, substantial Treasury issuance, stronger-than-expected economic activity, and renewed concerns over energy prices. Bond investors therefore faced meaningful price declines even as the economy avoided recession.
Geopolitics remained an important source of uncertainty. The continuing conflict involving Iran and the associated disruption to energy markets pushed oil prices materially higher during the quarter. Brent crude rose sharply in September as concerns about supply and shipping through the Strait of Hormuz returned to the forefront. Higher energy costs are particularly troublesome because they can simultaneously raise inflation expectations and reduce consumers’ real purchasing power.
Historically, geopolitical shocks tend to have their greatest economic effect through commodity prices, financial conditions, and confidence rather than through direct destruction of productive capacity. The current episode is no exception. Higher energy prices feed into transportation, manufacturing, agriculture, and consumer prices, while higher Treasury yields raise borrowing costs across the economy.
Economic growth remained surprisingly resilient. The latest official estimate available at quarter-end showed real GDP growing at a 2.2% annual rate in the second quarter, revised upward from the prior estimate. The third-quarter GDP report was not yet available as of September 30 and is scheduled for release October 29. The 2.2% figure therefore remains the appropriate latest reported measure rather than a completed third-quarter result.
The composition of growth was encouraging but also raised questions about sustainability. Consumer spending, investment, and exports contributed to the second-quarter expansion, while business investment continued to be supported by the rapid buildout of artificial-intelligence infrastructure. The economy has therefore remained considerably more resilient than many expected despite restrictive financial conditions.
INFLATION AND MONETARY POLICY
Inflation remains one of the defining economic issues of 2026. The latest official Consumer Price Index reading available at quarter-end showed headline CPI inflation of 3.4% over the prior twelve months in August, while core CPI increased 2.4%. The September CPI report had not yet been released as of September 30 and is scheduled for October 14. Inflation has therefore moved well below its post-pandemic peak but remains materially above the Federal Reserve’s 2% objective.
The Federal Reserve’s preferred measure of inflation also remained elevated. August PCE inflation was 3.4% year over year, while core PCE inflation was approximately 3.0%. At its September meeting, the FOMC’s median projection put 2026 PCE inflation at 3.7%, underscoring the central bank’s concern that the inflation problem has become more persistent than policymakers had hoped.
Under Chairman Kevin Warsh, the Federal Reserve has adopted a noticeably different communication philosophy from the approach associated with the preceding generation of Fed chairmen. Warsh has openly questioned the usefulness of extensive forward guidance, arguing that markets can become overly dependent on Fed communications and create a ‘hall-of-mirrors’ effect in which policymakers and investors begin reacting to each other’s expectations rather than to economic reality. He has also indicated a preference for less reliance on the traditional dot plot and for a quieter, more purposeful Federal Reserve.
Warsh’s economic narrative is also distinctive. Rather than treating inflation primarily as a temporary consequence of pandemic disruptions, supply-chain problems, tariffs, or individual commodity shocks, he has emphasized the Federal Reserve’s responsibility for maintaining price stability and has repeatedly stressed that inflation is not necessarily self-correcting. In his August Jackson Hole remarks, he described the 2% PCE inflation objective as a firm target, emphasized that ‘money matters,’ and argued that the Fed should pay closer attention to monetary and financial conditions. This represents a meaningful philosophical departure from the more explicit forward-guidance and communication-heavy approaches associated with Jerome Powell, Janet Yellen, Ben Bernanke, Alan Greenspan, and other recent Fed leadership.
The September FOMC meeting reinforced the difference. The Committee unanimously raised the federal funds target range by 25 basis points to 3.75%-4.00%, citing solid economic activity, resilient domestic spending, strong productivity and capital investment, and inflation that remained elevated. The September projections placed the median year-end 2026 federal funds rate at 4.1%, higher than the June projection of 3.8%. The message was therefore less about promising a particular future path and more about restoring price stability through a policy stance that can adjust as the evidence changes.
This approach creates a more uncertain communications environment for investors. Under prior chairmen, markets often placed substantial weight on explicit guidance concerning the likely direction of rates. Warsh is intentionally reducing that guidance. In our view, this may increase short-term volatility, but it also has the potential to reduce the risk that investors become excessively dependent on the Fed’s forecasts and communications.
REAL ESTATE AND CREDIT CONDITIONS
The housing market is beginning to show more visible signs of strain. Mortgage rates moved sharply higher during the quarter as Treasury yields rose. By early October, the average 30-year fixed mortgage rate reached approximately 7.28%, the highest level since November 2023. Freddie Mac’s weekly survey had reached 7.03% on September 24, its highest reading since January 2025. Different surveys and daily market measures vary, but the important point for investors is that mortgage rates have returned decisively above 7%, materially reducing housing affordability.
The effect is increasingly visible in housing activity. Existing-home sales fell 2.0% in August to an annualized rate of 3.98 million, the lowest level in more than a year, while inventory rose to approximately 1.62 million homes, equivalent to roughly 4.9 months of supply. Pending home sales were also down 4.7% from a year earlier. New-home purchase mortgage applications declined for the fifth consecutive month, and builders have increasingly relied on price reductions and incentives to attract buyers.
Housing affordability has become a significant constraint. Higher mortgage rates are occurring alongside home prices that remain near record levels, producing monthly payments that are substantially higher than they were several years ago. The result is a market characterized by limited affordability, cautious buyers, and homeowners who remain reluctant to give up existing mortgages carrying substantially lower rates. We believe real estate represents an increasingly important transmission mechanism through which higher interest rates can eventually slow the broader economy.
Credit markets also deserve continued attention. Corporate credit spreads remain relatively narrow by historical standards even as Treasury yields have risen and economic uncertainty has increased. Investors should therefore remain selective. Higher government borrowing needs, elevated interest expense, and the possibility of slower growth create a less favorable backdrop for lower-quality borrowers than the level of credit spreads alone would suggest.
INVESTMENT OUTLOOK
We continue to believe investors should prepare for a more volatile market environment during the balance of 2026 and into 2027. The economy is not presently signaling an imminent recession, and corporate earnings remain healthy. However, the combination of elevated inflation, higher long-term interest rates, expensive segments of the equity market, geopolitical uncertainty, and deteriorating market breadth creates an increasingly asymmetric risk environment.
The contrast between the S&P 500’s modest quarterly gain and the fact that roughly 59% of its constituents were in bear-market territory deserves particular attention. Market capitalization weighting has allowed a relatively small number of very large companies—many of them associated with artificial intelligence—to offset weakness elsewhere. This concentration can persist for some time, but it also means that the headline index may provide a misleading picture of the experience of the typical stock.
Artificial intelligence remains a powerful source of productivity and capital investment, and we continue to recognize its long-term economic significance. Nevertheless, portions of the market appear to discount exceptionally strong growth for many years into the future. As history has demonstrated, technological progress and attractive investment returns are not synonymous when expectations become excessive.
Higher interest rates also change the relative attractiveness of different investments. Long-term bonds have become more appealing from an income perspective, but investors must recognize the price risk created by rising yields. Equities remain supported by strong earnings, but higher discount rates place greater pressure on valuations. Real estate faces the additional challenge of financing costs and declining affordability.
Conversely, periods of elevated uncertainty frequently create opportunities in areas of the market that have been overlooked or temporarily discounted. Our investment philosophy continues to emphasize identifying businesses and assets trading below our estimate of intrinsic value rather than attempting to predict short-term market movements.
The combination of persistent inflation, a more hawkish Federal Reserve under Chairman Warsh, elevated government borrowing, rising mortgage rates, geopolitical tensions, and unusually narrow market leadership suggests that volatility should remain a defining characteristic of financial markets. We believe investors should be particularly cautious about extrapolating recent index performance into the future.
As always, we remain disciplined in our investment process. We continue to emphasize quality, valuation, diversification, and patience. Periods such as these often test investor resolve, but they can also create the conditions for attractive long-term opportunities.
Rather than attempting to forecast every short-term market movement, we believe successful investing continues to be grounded in thoughtful analysis, prudent risk management, and the willingness to capitalize on opportunities created by periods of uncertainty. The market’s internal weakness during the third quarter is a reminder that the best investment opportunities are not always found in the areas receiving the most attention.
Important Information
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such. The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
Artificial Intelligence (AI) :
Use Disclosure Portions of this communication may have been prepared with the assistance of artificial intelligence (“AI”) and other automated tools. These tools may use third-party data, models, and algorithms that are subject to limitations, including potential inaccuracies, biases, and changes over time. Any references to models, scenario analysis, or projections are for illustrative and educational purposes only, are inherently uncertain, and do not guarantee future results. The information provided does not take into account your specific objectives, financial situation, or needs and should not be construed as a recommendation, offer, or solicitation for the purchase or sale of any security or the adoption of any investment strategy.
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