Smooth Seas with Sharks Below | Strategy Update

Picture yourself on a beautiful sailboat on a clear summer day. The sun is shining, the water is calm, and the wind is at your back. That is what today’s financial markets feel like. But look just beneath the surface and you may spot a few dorsal fins circling. Markets are strong – genuinely fundamentally strong – yet there are risks that deserve our attention. With that backdrop in mind, let’s dig in.

A Powerful Bull Market – With Good Reason

It is important to begin where the evidence points: the fundamentals underpinning today’s market may be as strong as they have been in decades. This is not euphoria masquerading as fundamentals. There are real structural reasons why stocks have significantly outperformed bonds and real estate over the past six months.

We are currently in year three of what we believe to be a longer-term business cycle with the potential to last eight to nine years. What makes this cycle particularly powerful is the driving force behind it: artificial intelligence. Technologies that meaningfully improve productivity – allowing companies to do more with the same people and infrastructure – have historically been rocket fuel for business cycles, corporate earnings, and the broader economy. We are witnessing that in real-time today.

This business cycle is reminiscent, in many ways, of the one we experienced in the 1990s, when the internet revolution powered a decade-long expansion. GDP growth, currently running at approximately 2%, could accelerate toward 4% as AI-driven productivity gains take hold. Corporate earnings are growing, valuations in the AI trade remain reasonable relative to growth rates, and there is no shortage of opportunity for long-term investors. Importantly, we do not see the hallmarks of a true bubble. Price-to-earnings ratios in AI-related companies, while elevated, are far more modest than what preceded the dot-com collapse of the late 1990s. Our six proprietary market metrics do not suggest an imminent broad market unraveling or “bubble popping.”

In short: this is a bull market, and it has room to run.

One Notable Caution: Investor Confidence Is Running Hot

That said, our enthusiasm is tempered by one important near-term concern – investor psychology. When markets are generous, as they have been, confidence has a way of getting ahead of fundamentals. Investors begin to feel that success is inevitable; that risk has disappeared; that the gains of recent months are simply the new baseline. History tells us this is precisely the moment for discipline.

We track what we call the “curve of confidence” – a framework that maps investor sentiment from early optimism through thrilled, to overconfident, and ultimately, to the kind of euphoria that precedes meaningful corrections. Today we believe sentiment is running somewhat ahead of itself. That does not mean the bull market is over – far from it. But it does suggest that a period of volatility this summer, particularly in technology stocks that have appreciated dramatically, would not be surprising. Such a pullback would be a normal, healthy part of the cycle – not a reason to exit equities. We expect stocks to be higher by year-end and for the next several years. But markets have a way of humbling even the most confident investors before continuing higher, and we want our clients to be prepared for that possibility.

International Stocks: A Reminder That Diversification Works

One defining characteristic of this market cycle that deserves emphasis: foreign stocks continue to meaningfully outperform those from the U.S. This is not a temporary anomaly. International stocks are cheaper on a valuation basis. Many are participating in the same AI-driven productivity cycle, and a weakening US dollar has provided an additional tailwind for dollar-based investors holding foreign assets.

This is precisely why approximately 40% of client stocks at Main Street Research are companies domiciled outside the United States. Those holdings are denominated in local currencies, which provides a natural hedge against continued U.S. dollar weakness. Global diversification, long underappreciated after years of U.S. market dominance, is once again being rewarded in a meaningful way.

The Sharks in the Water: Three Risks We Are Watching

Even on a beautiful day, a prudent sailor keeps an eye on the horizon – and below the surface. With markets performing well, we believe it is especially important to be transparent about the risks we are monitoring closely.

Oil and the Strait of Hormuz

The most immediate risk is the price of oil and the continued closure of the Strait of Hormuz. Elevated oil prices are not merely a concern at the gas pump – they are inflationary across the entire economy, from transportation to manufacturing to consumer goods. Sustained inflation of this kind forces central banks, including the Federal Reserve, to maintain or raise interest rates, which in turn slows economic growth. Left unresolved, a prolonged closure of the Strait could move from a market headwind to a genuine threat to this business cycle. This is the shark swimming closest to the boat. If the Strait reopens, we believe this risk dissipates quickly and the bull market continues largely uninterrupted. We are watching this development closely.

Private Credit: A Young but Growing Shark

The second risk, or shark in the water, is less immediate but worth monitoring: the growth of the private credit industry. In the years following the 2008 financial crisis, stricter bank lending standards created an opening for private credit firms – non-bank lenders that provide financing to mid-sized businesses. This shadow banking sector has grown dramatically, and in recent quarters defaults on lower-quality loans have begun to rise. Investors in some private credit vehicles are becoming cautious, and that caution has the potential to create a downward spiral that could eventually touch the broader banking system, given that major financial institutions have significant exposure to private credit companies. We do not view this as systemic at present, but it is a risk we are actively tracking. It is the kind of threat that can appear manageable until it is not.

US Debt: The Largest Shark

The third and most significant risk is one that has been building for years: the level of United States sovereign debt. The U.S. has now reached $40 trillion in total debt, and the country continues to run at an annual deficit of approximately $2 trillion. Interest payments alone now approach $1 trillion per year. As a point of reference, should oil prices and inflation remain elevated, interest rates are likely to rise – meaning the cost of servicing that debt will only grow. The U.S. dollar has declined materially over the past 18 months, a signal that some foreign investors are beginning to reconsider their appetite for dollar-denominated assets.

This is not an immediate crisis, but it is a long-term structural challenge. In years – not decades – the trajectory of U.S. debt, if uncorrected, risks a credit downgrade, which could diminish foreign demand for U.S. Treasurys and create significant disruption across global financial markets. The most credible solution is one that has a historical precedent: the 1990s internet boom generated such powerful economic growth and corporate tax receipts that it effectively addressed the debt-to-GDP imbalance of that era. AI-driven productivity growth has the potential to do the same today. We are hopeful – and watchful.

What We Are Doing About It: Active Risk Management

Our job is not simply to identify risks – it is to manage them on your behalf, regardless of market conditions. In a bull market especially, discipline matters.

Our Active Risk Management process gives us the flexibility to reduce equity exposure if market conditions deteriorate beyond normal volatility. We can also rotate into more defensive sectors – healthcare, consumer staples, utilities – that tend to hold up well when broader markets come under pressure. And we maintain stop-loss disciplines on individual positions, allowing for normal volatility while seeking to mitigate the effects of significant single-stock declines that may impair portfolio value. This approach has been a longstanding component of our investment process and remains central to how we invest today.

We continue to find well positioned opportunities across U.S. and international equities – in artificial intelligence, healthcare, industrials, and other areas of the market that are well positioned for this business cycle. Our portfolios are performing well relative to benchmarks, and we remain confident in our long-term view.

Our long-term target of Dow 100,000 by 2030 reflects our conviction that this technological Supercycle has meaningful room ahead. It is a beautiful day on the boat. The sharks are not close – but we know they are there, and we are watching.

From all of us at Main Street Research, thank you for your continued trust and confidence in our team. If you have questions about your portfolio or would like to discuss any of the themes covered in this update, please do not hesitate to reach out. And if you have a family member, friend, or colleague who might benefit from a no-cost portfolio review, we would be delighted to connect with them.

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