Two months ago we wrote that the Federal Reserve had almost no room to maneuver, and that long-term Treasury bond yields were rising in a way that most were choosing to ignore. In August, the market stopped ignoring it.

Over a single week, the market went from expecting the Fed to hold rates steady in September to expecting a rate increase. The 30-year Treasury yield briefly touched a level it had not seen in nearly two decades — and higher long-term yields usually have a negative effect on stock prices, because they give investors a safer place to earn a return. Yet stocks, which by conventional reasoning should have struggled against that backdrop, finished the month higher.

The S&P 500 returned 2.7% in August and is now up 13.1% for the year. The broadening we have written about in prior letters — the rotation away from a handful of giant technology companies toward smaller companies and a wider range of industries — played out largely as we expected, and we positioned for it.

A quick word on how we measure that. The regular S&P 500 gives the biggest companies the most weight, so a few giants can move the whole index. The equal-weighted version counts every company the same, which tells you how the typical stock is doing. This year the equal-weighted S&P 500 is up 15.6% against 13.1% for the cap-weighted S&P 500 index most people own. The Russell 2000, an index of small companies, is up 20.2%. The Magnificent Seven — Apple, Microsoft, Nvidia, Alphabet, Amazon, Meta, and Tesla, the seven companies that drove most of the market’s gains in 2023 and 2024 — have trailed the index this year. This is not seven companies dragging an index uphill. When smaller companies and the average stock are leading, the market is pricing in something more durable than momentum. We said that in May. We said it again in July. August did too — however, we think the tide may be shifting again.

Returns tell you what the market did. Fund flows — the money investors actually put into or pull out of mutual funds and ETFs each week — tell you what investors chose to do. In the week of August 19, for example, fund flows started reverting back to a preference for large-cap technology stocks.

While returns were spreading out across the market, new money was doing the opposite. Investors kept buying stocks, but they sent nearly all of it to the largest companies and pulled it from almost everywhere else. Small and mid-sized company funds lost money in the same month their share prices were leading. Every sector fund except technology saw withdrawals, with banks hit hardest — and even technology attracted only a trickle. The week that followed, ahead of Nvidia’s earnings and the Fed’s Jackson Hole meeting, brought the largest weekly outflow since March. The money is restless.

We took note and reduced exposure in financials and industrials. Those were the sectors investors were leaving in size, and we would rather move with a trend of that clarity than argue against it. In industrials, the case holds on its own terms: spending on new factory construction has fallen roughly a third from its 2024 peak, even as orders for equipment reached a record. The buildings are cooling while the machinery inside them accelerates. That is a more selective environment than a simple sector weighting can express.

Investors are not pulling money out of the stock market; they are repositioning. That is what investors do when they are unwilling to hold cash but no longer comfortable owning everything. If this trend develops further, the headline breadth numbers may be short lived.

American households now hold roughly 45.8% of their financial assets in stocks — close to the highest reading in a series that goes back to 1945. Foreign investors own approximately 18% of the U.S. stock market, a record share worth roughly $19 trillion, and they added a net $181 billion in June alone.

Set those figures beside a personal saving rate of 3.0% — up from 2.6% in June, but still barely a third of its long-run average of 8.4% — and the position of the American investor becomes clear. Exposure to stocks has never been higher. The cash reserve behind it has rarely been thinner. When the typical investor is already all-in on stocks and has little cash set aside, a shock forces selling rather than inviting a decision. We are not forecasting that outcome. We are noting that the path from a shock to forced selling is shorter than it has been in a very long time.

Energy led all sectors in August with a 7.0% gain. Technology followed at 6.2%. Utilities was the weakest sector at −4.8%.

As we predicted, the winners and losers are shifting. Software stocks rose roughly 16% for the month. Semiconductor stocks — the companies that make the chips behind AI — rose about 1%.

In July we suggested the market was beginning to shift its enthusiasm from the companies building AI infrastructure toward the companies putting it to use, which is exactly what unfolded. Semiconductor giant Nvidia reported revenue up 106% from a year earlier and forecast higher sales for the coming quarter than Wall Street expected — and the chip sector still could not hold its gains. We do not read this as the end of the AI investment cycle. We read it as a maturing one, in which building capacity alone no longer commands the premium it once did. Investors are paying for adoption now. They are not as willing to pay simply for scale.

Kevin Warsh delivered his first Jackson Hole address as Chair, and he was direct in a way Fed chairs rarely are. He described inflation as sustained and elevated rather than fading, and put the responsibility squarely on his own institution:

The probability of a September rate increase moved from roughly 35% to 66% in the days surrounding the speech. The 30-year Treasury yield briefly exceeded 5.3%, its highest in about nineteen years. The ten-year finished the month at 4.75%. Thirty-year mortgage rates sit near 6.71%.

Then the August employment report arrived and made his case for him.

Employers added 162,000 jobs against expectations of roughly 53,000. Unemployment held at 4.1%. June and July were both revised higher. A Fed worried about lingering inflation and looking at a job market that refuses to soften does not cut rates into a consumer slowdown. It waits.

We no longer have high expectations for a rate cut in September. We do not believe the Fed is coming to lift this market by cutting rates. Thankfully, it may not need to — the earnings picture has taken center stage.

Second-quarter earnings were the strongest since 2021: combined profit growth of 52%, revenue growth of 15.5%, 86% of companies beating on earnings, 77% beating on revenue.

A word on what “beating” means. Analysts publish profit estimates before each quarter; a beat is when a company reports more than expected. At first glance this quarter looks extraordinary: companies exceeded estimates in aggregate by 26.5%, against a five-year average of 7%. But strip out Alphabet and Amazon — both of which recorded large gains on investments they hold (Amazon’s stake in Anthropic, Alphabet’s holdings) that accounting rules count as profit, even though they have nothing to do with day-to-day operations — and that figure falls to 10.8%.

When a company beats estimates because its stock holdings appreciated, that tells you something about asset prices. It tells you considerably less about the underlying business. What that means is that choosing individual companies carefully matters more here than the index-level number suggests.

The forward price-to-earnings ratio on the S&P 500 fell from 20.0 in early August to 19.6 by month-end, even as the index rose. A price-to-earnings ratio is simply what investors pay for each dollar of profit a company is expected to earn over the coming year. It falls when expected profits grow faster than share prices. In August, they did. Stocks went up, and analysts raised their earnings forecasts by more.

The encouraging reading is that this rally is being paid for. The market is not getting more expensive as it climbs; it is getting slightly cheaper, because the earnings underneath are growing faster than the prices on top.

The cautious reading is that the ratio only falls this way if the forecasts hold. Those are analyst estimates, not results, and twelve-month-forward estimates are the most optimistic figures in any cycle — historically they are revised down far more often than up. If expectations come back toward earth, the arithmetic runs in reverse: prices unchanged, estimates lower, ratio higher, and a market that suddenly looks expensive. Our read is that the valuation numbers are encouraging, but we are keeping a watchful eye on this to steer our thinking away from the “the market is too expensive” outlook in the headlines.

Wages rose 3.1% over the past twelve months. The Fed’s preferred inflation gauge ran near that number, depending on whether food and energy are included. What is notable is the personal saving rate stands at 3.0%, against a long-run average of 8.4%. The cracks are beginning to show against the sustainability of the consumer as credit card and auto loan delinquencies are at levels last seen around the start of the 2008 financial crisis. July retail sales fell 0.6% — the first monthly decline in nine months.

Consumer spending is roughly 68% of the American economy. Corporate profits at current levels are being supported, in part, by households drawing down savings rather than growing income after inflation. Record profit margins are real. So is the question of how much longer that arrangement holds. The gap closes eventually. The only question is from which side.

We are near fully invested and hold more energy stocks than the index does. Energy has been our strongest contributor this year, and it doubles as protection if a supply disruption — a closure of the Strait of Hormuz, through which roughly a fifth of the world’s oil passes, or an escalation in a producing region — pushes oil prices sharply higher. That is an efficient position to carry.

A supply shock, where oil becomes scarce, rewards energy and commodities. A demand shock, where people stop spending, does the reverse, because when spending falls, so does the price of oil. The conventional remedy — owning a wider range of assets — is less effective than usual right now, because stocks, bonds, and commodities have been moving together more than they usually do. Our job gets tougher.

We are approaching early fall with the perspective that our strategy this fall is less about adding hedges and more about pressure-testing what we already own. Much of our analysis will be running the portfolio against each plausible outcome.

In conclusion, our attention will be on the following themes:

• 01
  Flows against price.Whether money begins returning to mid- and small-cap funds, or whether consolidation into large-cap and technology continues. Flows have been the better early indicator this year.
• 02
  The household balance sheet.Savings, delinquencies, and retail sales, which should tell us whether spending is slowing before earnings estimates begin to reflect it.
• 03
  The Strait of Hormuz.A variable capable of repricing energy, inflation, and rate expectations very quickly, and the primary reason our energy position is sized as it is.
• 04
  The midterm elections.Now eight weeks away, on November 3. We will address them properly next month. Our early view is that divided government — one party holding the White House and the other holding at least one chamber of Congress — constrains legislation, and legislation has not been the mechanism moving this market.

Keep in mind, none of the scenarios above is a prediction. They are the places where we think this market is most likely to be tested, and we would rather name them in September than explain them in December.

We will continue our pattern of following the evidence, and keeping you up to date when it changes. Nothing in the current data asks us to reduce risk. Several things in it ask us to pay close attention, and we are.

— Meridith L. Hutchens, Fortis