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Low quality stocks dominated last year, but valuations and fading momentum make them look risky now.
The rally in speculative, low-quality stocks that began last April took a breather in the fourth quarter. AI linked names, meme stocks and crypto lagged while value and international names outperformed the S&P 500. However, this weakness did not significantly reduce the outperformance of low-quality stocks for the year. The performance impact was most pronounced in small caps, where over 40% of the Russell 2000 Small Cap Index consists of money-losing companies. Within that universe, high quality small cap stocks lagged low quality by over 12 percentage points. Despite this recent underperformance, higher quality small cap stocks retain their longer-term outperformance. International equities delivered their strongest relative performance versus the S&P 500 since 1993, with both the MSCI EAFE Index of developed markets and the MSCI Emerging Market Index outperforming the S&P 500 by over 13 percentage points.
If all economists were laid end to end, they would not reach a conclusion. – George Bernard Shaw
As we enter 2026, the investment landscape sits at a delicate balance of risk and opportunity. On the positive side, accommodative monetary policy, resilient corporate profitability, and pro-growth fiscal and regulatory measures provide a supportive backdrop. High-end consumer spending, AI infrastructure investment and productivity enhancements remain tailwinds. However, fading AI stock momentum, elevated valuations, inflationary pressures, and a widening U.S. budget deficit could challenge market stability. A weakening job market for white collar and tech workers and pressures on lower income consumers from inflation and debt places a downward pressure on overall consumption. These positive and negative factors balanced one another in 2025 so that the economy could grow 4.3% while inflation fell below 3%. Whether this balance can continue in 2026 will determine market performance. For investors, this environment underscores the importance of maintaining a disciplined, long-term strategy rather than chasing short-term narratives.
This year’s investment outlooks published by investment banks and large investment managers suggest a benign market environment, with expectations for a broadening of U.S. equity performance beyond mega-cap technology. Small-cap stocks and Japanese equities are viewed favorably, while emerging markets—particularly India—are projected to deliver the highest economic growth rates globally. These forecasts imply opportunities for diversification across geographies and market capitalizations, though execution will require careful attention to valuation and liquidity considerations. However, the highest risks and returns often come due to unexpected events causing markets to move contrary to consensus narratives.
‘AI bubble’ risk concentrated on a smaller tier of lower quality companies
The bulk of the estimated $644 billion1 invested in AI last year was used to fill data centers with servers running NVIDIA’s latest chips. Chips are not long-lived assets. NVIDIA’s latest GPUs have a 3–5-year lifespan under heavy data center workloads. As companies increasingly turn to debt financing, concerns about a bubble have increased. However, exposure in client portfolios centers on the hyperscalers with fortress balance sheets – Microsoft, Alphabet and Amazon. Their debt carries AA or AAA ratings which can be easily supported by company cash flow. Meta and Oracle have been more aggressive debt issuers, but they remain at the lower end of investment grade. There is a layer of traditional real estate finance for data centers where the risk stems from the quality of the tenant. After this, the picture gets riskier and more complex. A subindustry of ‘neo-clouds’, such as CoreWeave, operates business models that involve borrowing to purchase fast-depreciating GPU chips that they then lease out. Finally, several crypto-mining companies have pivoted to leasing out their servers for AI and are forced to borrow at prohibitively high rates of interest to finance their operations. A change in sentiment toward AI would result in manageable underperformance for the hyperscalers but likely bankruptcies and permanent destruction of capital for the neoclouds and former crypto-miners.
AI investment driving record bond issuance and stock IPOs in 2026
While bonds delivered good returns in 2025 and two expected rate cuts this year bode well for fixed income investors, a record amount of new investment grade corporate bond issuance will hit the market this year, most of which will be driven by AI investment. Forecasts range from $1.6 trillion to $2.5 trillion of gross issuance2 . Adjusting for refinancings and maturities, this translates to a net increase in outstanding bonds of as much as $1 trillion, or about a 12% increase in the total market size. These bonds will be predominantly 10-year maturities so the impact will be felt at the longer end of the curve. It remains uncertain whether this supply pressure will stay confined to corporate credit or spill over into other areas of the fixed‑income market. Municipals should remain unaffected given the current wide tax-equivalent yields and different investor base, but the corporate issuance could impact 10-year treasury yields. A worst-case, but by no means catastrophic, scenario would involve a steepening of the yield curve in the 7-10+ year range, negatively impacting investors in longer-term bonds. Our positioning outside of tax-exempt municipal bonds throughout last year had been to focus on lower (1-5 year) duration, and this looks to be a good policy for 2026.
The equity markets also will likely see an influx of new issuance. SpaceX, OpenAI, rival AI provider Anthropic, data engineering platform Databricks and payment processor Stripe are among the companies expected to go public this year. Based on current private‑market valuations, these five companies collectively represent nearly $3 trillion in potential market capitalization. Relative to a total S&P 500 market cap of nearly $60 trillion, this represents about a 5% increase in the opportunity set for US stocks.
Databricks and Stripe have reported they are currently profitable while Space X, OpenAI and Anthropic are still scaling up to achieve profitability. A public offering of OpenAI and/or Anthropic will provide greater clarity on the economics of artificial intelligence and these stocks will compete for investor dollars against existing tech names.
Despite headline-driven volatility and thematic booms, diversified portfolios anchored in quality remain the most reliable path to long-term success. As we look ahead to 2026, opportunities abound—but so do risks. Portfolios should be designed to navigate these dynamics, remaining aligned with your objectives and resilient across a range of potential outcomes.
- www.hostinger.com/tutorials/llm-statistics ↩︎
- Source: Apollo Investments survey of 10 Wall Street Investment Banks ↩︎