Bullish signals, concentration risk, and credit cockroaches

Referring to recent bankruptcies in the headlines, Jamie Dimon commented, “...when you see one cockroach, there’s probably more."¹ As our Asset Allocation Committee discussed whether we’re about to enter a credit cycle blow-up (we don’t think we are), one committee member wondered out loud, “Isn’t there a difference between a potential fraud cockroach² and a default cockroach?”

The delicate balance between negative signals—high valuations, possible cracks in the economy, and “cockroaches”—and positive ones—massive artificial intelligence (AI) spending, strong corporate earnings, and Federal Reserve (Fed) rate cuts—provided the backdrop for yet another one of our epic bull versus bear debates.

In the end, we decided to maintain a neutral stance on equities, balancing solid fundamentals with expensive valuations.

Tactical and structural considerations

“It’s hard to see what stands in the way of a continued rally for the next six months,” a committee member said, reflecting the dominant but cautious optimism. Fundamental and macro factors are supportive of risk assets:

• The Fed is expected to cut another 125 basis points³
• Fiscal policy is loose
• AI-related investment is driving corporate spending
• Earnings are growing at 10% to 12%⁴
• Liquidity remains abundant

Over the past three months, small-cap, emerging market, and real-asset segments—especially precious metals—have outpaced large-cap growth stocks.⁵ Performance has broadened.

But other members were less sanguine. Are we in an AI bubble?*

“There’s uncertainty because we’re in a data blackout,” one member said, referring to delays in official economic data due to the federal government shutdown. Another noted that “the web of circular deals in the AI buildout looks like vendor finance from the dot-com era.” Yet another framed the tension created by high valuations this way: “I don’t buy into the narrative that because everyone says we’re in a bubble, it means we’re not in a bubble.”

“I’m structurally bearish but tactically bullish,” summarized a member—to which another replied, “I’m tactically bearish but structurally bullish.”

Credit market cracks?

We reaffirmed an overweight to high yield debt. Demand for credit remains steady despite isolated defaults. “High-profile bankruptcies may shift sentiment in the lowest-quality part of the high yield market,” a committee member said. “But First Brands and Tricolor don’t seem to be strictly credit events; leverage and interest coverage look decent; and there’s no rush to CCC rated bond issuance⁶ or aggressive leveraged buyouts, so it doesn’t feel like a late-stage credit cycle.”

While spreads are tight, total yields remain attractive, and fundamentals don’t yet signal the start of a credit downturn. Plus, it’s important to keep current spread levels in context. As Arif Husain, T. Rowe Price head of Global Fixed Income and CIO, has highlighted, today’s spreads reflect several shifts in credit markets.⁷ A general decline in sovereign credit quality has made the “risk-free rate"⁸ somewhat riskier.

Upside inflation risks

Markets seem to have taken solace from the lower-than-expected readings in September Consumer Price Index data, but we don’t see a let-up in the larger, structural forces driving inflation risks to the upside:

• Energy demand. Data center spending is at record levels.⁹ I’m noticing more headlines about rising electricity prices hitting pocketbooks.
• Geopolitical uncertainty. We’re keeping a close eye on food prices amid tariff and other policy risks.
• Fiscal stimulus globally. Germany is set to ramp up spending on defense and infrastructure, and Japan’s recent election results suggest that even more stimulus is on the way.

For all the talk of labor market softness, wage gains have remained solid. Retail spending is also holding up, enabling companies to keep passing along higher prices. As my colleague Blerina Uruçi, T. Rowe Price chief U.S. economist, recently pointed out in a TV interview, the ingredients for a reflation trade are in place.¹⁰

We continue to favor real assets equities (in addition to inflation-linked bonds) in this environment. The steady drivers behind gold’s melt-up, such as central bank buying and a weaker U.S. dollar,¹¹ have added to the case for real assets exposure.

Duration

Partly related to our inflation view, we continue to underweight duration in fixed income. We discussed whether to lengthen our duration position as the Fed cuts. “It’s becoming a bold call to say the 10-year [U.S. Treasury yield] ends higher in a cutting cycle,” one member said. Still, fiscal stimulus, persistent deficits, and heavy Treasury issuance suggest upward pressure on yields. For now, we will hold our short duration stance.

Prepared for a wide range of outcomes

Earnings and liquidity remain supportive, but valuations leave little room for disappointment.

We’re holding risk assets neutral, overweighting high yield for carry, staying short duration for flexibility, and maintaining moderate overweights in real assets and international equities. This posture provides diversification in a concentrated market. With the range of outcomes growing wider, a “muddle-through” scenario for markets seems increasingly unlikely.

“Neutral feels right,” a member concluded. “We're one data print away from conviction in either direction.”

*A note on valuations: On my Bloomberg Terminal, as of October 15, 2025, the forward 12-month aggregate price/earnings (P/E) ratio is at 22. Using monthly data from July 1994 to September 2025, we can compare average forward-year returns when the S&P 500 Index reached an all-time high versus when P/E ratios exceeded 21, helping us gauge the empirical probability of a muddle-through return (in the 5% to 15% range) over the next year (Fig. 1).

When the P/E is above 21, a muddle-through return is 44% less likely (18% probability versus 32% for the full sample). As a TV talking point, one could say “almost half as likely.”

Moving from data to anecdotes, there were only a few times in history when the P/E reached 22 on an uptrend (higher than the prior month), as it just did. Except for December 1999, forward returns in those periods were strong (Fig. 2). Committee members have been referring to this scenario as a “blow-off top.”

And before the crash of 2008? The P/E ratio was in the low to mid-teens (Fig. 3).