Red Light! … Green Light! Navigating Markets in a Complex Environment | Strategy Update

Growing up you may recall the red light/green light game. A challenge of knowing when to move forward (green light) or choose safety (red light). This comes to mind in today’s volatile, event driven financial markets as we face a mix of geopolitical uncertainty, shifting leadership, and evolving economic conditions. With ongoing conflict in the Middle East, questions around inflation, oil prices, and global growth have created a more complex backdrop for investors. We also have a forthcoming change of who will be chairing the Federal Reserve, disparity in the perception of the winners in AI tech stocks, as well as some significant cracks in private credit. With all these crosswinds is the light going forward green? Or is it now red? Let’s dig in!

Pre-war: A Healthy Set Up for Global Equities

It is important to recognize that prior to the Iran conflict, the setup for markets was very strong. Global equities – not just U.S. stocks – were reaching new highs simultaneously, which is an indication of a synchronized business cycle and bull market. It is also important to recognize that we are in what we believe to be year three of a longer-term business cycle potentially lasting eight to nine years, supported by strong economic fundamentals.

This cycle is being driven in large part by technological innovation, particularly artificial intelligence, which is already contributing to higher productivity and corporate profitability. Importantly, before the war, valuations were not excessive, with many areas of the market – especially outside of AI and in international equities – remaining attractively priced.

The War Has – So Far – Set off a Normal Correction in Markets

The situation in the Middle East is first and foremost a humanitarian concern. From a market perspective, it introduces uncertainty, particularly through rising oil prices and their potential impact on economic growth.

Historically, wars and energy spikes can slow economies by increasing costs for both consumers and businesses. So far, however, markets have reacted with what we would consider a normal correction. While volatility has increased, it has not escalated dramatically, largely because the global economy entered this period from a position of strength, with solid employment and steady demand.

The key factor going forward is the duration of the war. A shorter conflict may have only a temporary impact, while a prolonged one could begin to weigh more meaningfully on growth and consumer spending. If the war drags on and the Strait of Hormuz remains shuttered, the global economy will weaken under the weight of higher oil and gas prices, which in time could set off a contraction in the global economy and significant weakness in corporate profits and stock markets. Though global central banks have room to cut interest rates to try to keep the economy from recession, it would be a difficult task. With that said, investors should embrace risk management tools such as our Active Risk Management process.

Why have AI Stocks Underperformed?

After a strong multi-year run, AI-related stocks have recently slowed or moved sideways, which has raised questions among investors.

This type of pause is not unusual. Markets often take time to digest gains, reassess valuations, and allow fundamentals to catch up with expectations. In many cases, this creates healthier long-term trends rather than signaling weakness and we would suggest that is the case.

The broader AI story remains intact, with meaningful applications across sectors such as healthcare, industrials, communications, and materials. As a result, recent pullbacks may represent opportunity rather than risk for long-term investors.

The Other Risks Investors Should Be Watching?

Beyond geopolitical developments, we are focused on several additional factors that could influence markets. These include the transition to a new Federal Reserve chair, potential shifts in monetary policy, and emerging concerns within private credit markets. While private credit is experiencing some stress, we view this as a contained issue rather than a systemic risk – not the potential for a broad financial crisis.

At this stage, the most important variable remains the geopolitical environment and its potential impact on oil prices, inflation, and overall economic growth.

Opportunities in Today’s Market

If the U.S. and its allies can come to terms for peace and the Strait is re-opened, we believe that stocks would experience a ferocious rally. Periods of uncertainty such as this one often create opportunity, particularly for long-term investors.

Many high-quality companies have pulled back alongside broader market volatility, improving valuations and creating more attractive entry points. Areas we find particularly compelling here in the U.S. and overseas include artificial intelligence, healthcare, industrials, financials, communications, and materials.

Managing Risk for the Red-Light Scenario

While we remain constructive on markets, risk management is central to our approach and becomes even more important in uncertain environments. If conditions deteriorate, we have the flexibility to reduce equity exposure, shift toward more defensive sectors such as healthcare, utilities, and consumer staples, and adjust positioning accordingly. In addition, we utilize disciplined stop-loss strategies to help manage downside risk and remove emotion from investment decisions.

Our objective is to participate in long-term growth while maintaining the ability to protect capital when needed.

While this is a complex and evolving environment, it is important to remember that the underlying foundation of the market remains strong. A resilient economy combined with ongoing technological innovation continues to support a constructive long-term outlook.

From all of us at Main Street Research, thank you for your continued trust and confidence in our firm. If you have any questions or would like to review your portfolio, please do not hesitate to reach out. We look forward to navigating the months ahead together.

If you have a family member, friend, or colleague who may benefit from our work or a no-cost wealth management and portfolio review, please let us know. We are always grateful for your referrals and your trust.

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