Domestic Equity Market Commentary – 3Q 2026

After the exceptional stock market performance last quarter, markets registered rather mixed results in the third quarter, as stabilization in the Middle East proved fleeting, inflation remained stubbornly high, the Fed finally made its hawkish turn, and, importantly, interest rates spiked to levels many of today’s investors have never experienced. The broad strength of the US economy proved to be the ballast against the storm of higher interest rates. Earnings growth remained excellent, with large cap corporate earnings growing by over 30%. The S&P 500 posted a 2.3% gain for the quarter which masked the narrowness of market returns, with the S&P Equal Weight Index declining by nearly 2%. Energy proved to be the strongest performing sector, up 17%, as oil prices gained 30%, retracing much of the prior quarter’s decline. Information Technology and Health Care also posted solid mid-single digit returns, the former on the strength of software and hardware companies, especially Microsoft and Apple, and the latter on the strength of biopharma and life sciences tools companies. AI-related stocks took a breather in the third quarter, with semiconductors, memory and infrastructure companies generally weak. In light of higher rates, the more cyclical and interest sensitive Utilities, Industrials, and Real Estate sectors were the worst performing in the quarter.

The narrowness of the market was especially evident down cap, as the more cyclically exposed Russell 2000 Index declined -7.2%; a huge deviation from last quarter’s gain of over 20%. The underperformance of small cap stocks versus large, measuring nearly 10 percentage points, was the largest in over a quarter century. Importantly, it erased nearly all of small cap’s year-to-date performance advantage over large. Among small cap sectors, Energy was the only one to post a gain for the quarter. Health Care posted only a modest loss, as life science tools and healthcare equipment stocks offset most of the losses among biopharma and services stocks. Broad weakness among Industrials and Information Technology stocks pushed those sectors to the bottom of the pack. Style factors favored quality attributes this quarter, reversing last quarter’s trend, as high beta, low ROE and non-earners underperformed.

Large-cap Value outperformed Growth by 1.7% in the quarter, led by Health Care and Energy and supported by weakness in Industrials and Consumer Discretionary. This extended Value’s year-to-date lead to 13%. Small-cap Value also outperformed by 4.5%, driven by Energy’s strength and Industrials’ weakness, bringing its year-to-date advantage to 6%.

The long list of positive market drivers remains intact, led by strong economic growth and exceptional corporate earnings growth, and supported by strength in AI-related spending. Both the ISM Manufacturing and Services readings remain in expansionary territory. The labor market is steady, with decent jobs growth and low unemployment. Consumer spending is still quite resilient despite continued low consumer confidence survey readings. However, one can’t ignore the long list of stock market concerns: the Iran conflict shows no signs of resolution, oil prices are high, inflation readings remain sticky, the Fed has turned more hawkish, and global interest rates are up to levels not seen in over two decades.

Yet with strong earnings growth in 2026 likely to continue into next year, market pundits have moved their focus out to 2027. With another year of double-digit earnings growth forecasted, the S&P 500 earnings could exceed $400. This has lowered the S&P 500’s P/E ratio to about 18.5x, for an earnings yield of 5.4%. Unfortunately, the increase in yields, with the 10-year Treasury at 5.3%, keeps equities relatively expensive at their modest premium to bonds. While smaller cap stocks have also shown excellent earnings growth, in the mid-teens, their relatively slower growth erased much of small cap’s valuation advantage over large caps.

Whether higher interest rates will pressure stock markets by putting a cap on valuation levels, or whether strong earnings will continue driving equities to record highs is unclear, with choppy markets still the most likely near-term scenario. Longer-term, we remain confident that the innovation, productivity gains, and cost savings of AI will drive economic growth, and push equity markets higher.

Along with all of its potential, the rapid advancement of AI also creates risks to existing business models and can rapidly change competitive dynamics. In this regard, our focus remains identifying financially strong, well-managed companies that can leverage technology, sustain leadership, and generate attractive shareholder returns. This is no doubt a difficult task in the early stages of technological change. But we remain confident in our ability to identify such winners through our deep research knowledge, long-term focus, and strong relationships with management teams.