The Contradiction of a Bifurcated Market: A Tale of Two Economies
The recent surge in the stock market, particularly in the tech-heavy Nasdaq 100 and S&P 500, presents a compelling narrative: the relentless march of technological progress, fueled by a boom in artificial intelligence (AI) infrastructure spending. However, this surge masks a deeper, more concerning story. The economy is becoming increasingly bifurcated, with strong, concentrated spending on AI technology on one side and a weakening consumer on the other. This dynamic creates a potentially dangerous contradiction that investors should navigate with caution, as it could lead to a sudden and significant economic slowdown.
The AI Rally: A Look at Soaring Valuations
The AI boom has propelled a handful of major companies to remarkable heights, with their valuations reaching levels reminiscent of the dot-com bubble. The S&P 500 now trades at a price-to-sales (P/S) ratio of 3.2, which is above the peak at the beginning of 2022 before the 27% selloff. In this recent bull market, we’ve seen several companies’ P/S ratios soar to levels above 25, a phenomenon that has historically been rare.
Wall Street and private equity firms are keenly aware of the opportunity to take advantage of these high valuations for tech stocks. For example, Figma, an AI-powered design firm, recently went public and its stock now trades for roughly $40 billion, or about 50 times its trailing 12 months’ sales. This is a significant jump from the $20 billion valuation for which Adobe was set to acquire it just two years ago, a deal that was terminated for antitrust reasons.
While the immediate excitement around AI has driven these gains, a look at history offers a cautionary tale. An analysis of companies that have historically held the highest P/S ratios shows that their outperformance is often short-lived. In the years following their valuation peaks, their returns tend to decline significantly, often lagging far behind the broader market. The high growth rates required to justify such elevated valuations are incredibly difficult to sustain over the long term. This suggests that the current rally, heavily concentrated in AI stocks, may be unsustainable without broader economic support.
A Sputtering Consumer Economy
While AI spending drives the market, the consumer side of the economy is showing signs of significant weakness. Consumer spending accounts for roughly 68% of the U.S. economy, and its growth has been stagnating, advancing 1.4% in the second quarter, which was an improvement from the 0.5% in the prior quarter, but still represents the slowest half-year of growth since the pandemic. This slowdown is especially apparent in lower-income households, suggesting that many consumers may already be “tapped out.”
In some cases, investors have begun to significantly lower expectations for consumer-related businesses. For example, companies such as Lululemon and Cava, former high-flying stocks, are down YTD by 47% and 38%, respectively, due to impacts from slower traffic and weaker-than-expected demand. As documented in prior notes, McDonald’s CEO Chris Kempczinski has also cited softening traffic and value-conscious consumer spending trends.
This consumer weakness is being compounded by the impending full impact of tariffs. Businesses have, until now, absorbed the higher costs from tariffs by using existing inventory and accepting slimmer profit margins. However, these “tariff buffers” are fading. As they disappear, costs will likely be passed on to consumers, which could intensify inflation. This morning’s Core PPI report showed a 3.7% Y/Y reading which was much higher than economists’ expectations for 2.9%. Tuesday’s Core CPI report showed inflation accelerating to 3.1% in July, the highest reading since February and well above the Federal Reserve’s 2.0% target. These reports are concerning, but it remains to be seen whether this is just a “one-time” price level increase, or a more alarming reignition of inflation.
One bright spot is the record level of home equity in the U.S., which has grown by an impressive 75% since 2020. This provides a stable foundation and a potential “wealth effect” that could support spending among this cohort. However, it may not be enough to counteract the combined pressures of prolonged inflation and trade tensions on the broader consumer base.
Navigating the Risk of Stagflation
Recent economic data, particularly the July jobs report, reinforces our concerns about a slowing economy. The report showed a much weaker-than-expected gain of just 73,000 nonfarm payrolls, and revisions to previous months brought the three-month average down to only 35,000 new jobs. This weakness in job growth, combined with slowing consumer spending and rising inflation, has led many to believe that the risk of a recession is not to be ignored.
The Fed is now widely expected to lower interest rates beginning in September, despite the stubbornly high inflation readings. Political pressure and the fear of being late to lower rates in the face of a softening labor market are forcing the Fed to act. However, a lower Fed funds rate may cause the long end of the yield curve to rise, potentially negating the intended effect of stimulating the economy.
A sudden economic slowdown in the second half of 2025 could surprise investors. This slowdown could take the form of stagflation—a combination of stagnant growth and rising inflation. The market’s dependence on AI spending while consumer spending softens creates a significant risk. The lesson of history is that extended stock market valuations without broad economic support are vulnerable to a sudden downturn. As such, this is not a time to become complacent.
Actress Halle Berry is 59 today, basketball star Magic Johnson turns 66, and actor Steve Martin turns 80.
Christopher Gildea 610-260-2235