Energy Inflation, Bond Market Sell-off, and AI Bubble All Apply Pressure—Is the Year-End Rally for U.S. Stocks in Jeopardy?

According to Intelligent Finance APP, despite the recent pullback, the S&P 500 Index and Nasdaq 100 Index are still near all-time highs. In the eyes of bulls, the US stock market is likely to see a rally before the end of the year, as has been the case for years. However, some analysts believe that the sell-off in US stocks has not ended and may even just be beginning.

Bulls Still Look Forward to Year-End Rally

In the bullish scenario, oil prices will fall back in some way before the end of the year, thereby weakening market expectations for the Federal Reserve to raise rates in 2027; the 10-year US Treasury yield will somehow drop to 5% or below; and earnings growth momentum will continue, especially with AI-related trading. All these factors would drive US stocks to end the year at all-time highs, with the S&P 500 Index reaching or exceeding 8,000 points.

There are also many bullish voices among Wall Street institutions. As tech stocks have come under continued pressure recently and investor sentiment has taken a hit, well-known financial research firm The Kobeissi Letter has issued a contrarian bullish view. Its latest report shows that while US equity market benchmark indices are still high, valuations have already “gone through the winter.”

Analysts at The Kobeissi Letter believe the US stock market is experiencing a “stealth bear market,” which represents “one of the greatest opportunities in today’s market.” This judgment mainly comes from valuation multiple compression. Energy inflation, US Treasury yields, and rate hike expectations have pushed down the valuation multiples that the market is willing to pay; if these pressures ease and earnings continue to deliver, tech stocks led by the “Magnificent Seven” could see a strong valuation recovery.

Although benchmark stock indices are near record highs, The Kobeissi Letter contends that the valuations of some tech companies, whose fundamentals are far ahead of the market benchmark, have already reflected a significant and unreasonable discount effect.

For example, Nvidia’s stock price rose 21% over the past 12 months, but its P/E ratio dropped by 46%; the current forward P/E ratio is about 24, close to the S&P 500 Index’s 22 times. Speaking of Nvidia, analysts commented: “Even though earnings growth was immensely strong over this period and analysts raised their forecasts, driving the stock up 21% and market cap to a solid $5 trillion super level, the P/E ratio fell by 46%.”

The institution also points out that the forward P/E ratio for the S&P 500 information technology sector is now almost identical to that of the overall S&P 500 Index—a very rare phenomenon. Historically, tech stocks “have almost always enjoyed a significant valuation premium relative to the broader market.” Therefore, the institution believes this valuation compression has formed a “stealth bear market," depressing the overall valuations of the world’s largest tech giants.

Their senior analyst team wrote: “If this context is eventually omitted from market pricing, it could trigger another strong rally in the S&P 500 Index, where tech giants occupy about 40% of the weighting.” They added, “If the breadth of the rally expands just a little, buying power will quickly accelerate as well.”

Goldman Sachs’ flow-of-funds team provides another bullish clue—the reopening of corporate buyback windows, year-end retail inflows, and post-election foreign buying could all bring incremental demand for beaten-down stocks. Regarding AI semiconductor assets that previously faced concentrated heavy selling, Goldman’s analyst team emphasizes that even a modest increase in buying could noticeably drive a price recovery. However, such support would first affect the overall market, and where funds ultimately flow in large scale still depends on which companies can provide new evidence of earnings growth this reporting season—AI computing-related semiconductor stocks and cloud computing leaders may have the advantage.

In sum, both institutions point to high-quality, growth-oriented tech assets with sustained strong earnings delivery as those most likely to benefit from both a capital return and valuation recovery.

The Sell-Off May Just Be Starting

However, from the perspective of more cautious investors, the likelihood of the bullish scenarios listed by the bulls materializing is very low, and the current US market pullback is very likely to evolve into a deeper correction.

Firstly, the inflationary impact driven by energy may be difficult to eliminate. Analysts point out that the immediate trigger for the sell-off that began on October 14 was the market’s reaction to a US September CPI report that exceeded expectations. With core inflation remaining high and still rising, the Federal Reserve must remain vigilant, take proactive action, and tighten policy rates even more aggressively; the market has also started to price in a more aggressive rate hike cycle from the Fed in 2027.

The surge in energy prices is the biggest driver of rising US inflation pressure. Although bulls hope oil prices will fall before the end of the year, the probability is very low. Tensions in the Middle East are escalating—fighting has spread from the Strait of Hormuz to areas around the Bab el-Mandeb Strait and may disrupt recently recovering Middle Eastern oil supplies. Additionally, global oil inventories are being depleted. All of these point to the likelihood of oil prices rising further after the US midterm elections, possibly leading to an energy price shock similar to 1974. Clearly, this would force the Federal Reserve to take even more aggressive rate hikes.

Secondly, the global bond market sell-off is likely to persist. Investors have realized that Western countries are still maintaining post-pandemic fiscal stimulus policies, but debt levels in the US, France, Japan, and many other countries are now unsustainably high. However, neither the US nor other affected countries are willing to cut spending or raise taxes. Thus, the sell-off in global bond markets is likely to continue.

Long-term bonds are not even too worried about oil price increases—the rise in the US 10-year Treasury yield has mostly been driven by real yields. The breakeven inflation rate on inflation-protected bonds has remained stable, indicating that investors expect the energy shock to be temporary. The risk, however, is that bond investors may be underestimating the impact of rising energy prices on inflation, as well as persistent core inflation. This means that as inflation expectations rise, nominal yields may go even higher.

Moreover, the AI narrative that has underpinned the US stock rally over the past few years seems to show signs of a bursting bubble. Concerns around the sustainability of AI financing deals and whether massive investments in compute power will ultimately generate sufficient revenue and cash flow continue to grow. Compared to its record high in June, the Philadelphia Semiconductor Index has already fallen by more than 20%, entering a bear market.

As concerns over inflationary pressures and fiscal status push up US Treasury yields, the era of cheap funds that defined the first nine months of this year has begun to fade. Luis Alvarado, Co-Head of Global Fixed Income Strategy at Wells Fargo Investment Institute, said that while investors were once excited about catching the AI wave, market sentiment has started to shift, and now investors are demanding higher risk compensation.

Analysts point out that AI infrastructure is essentially selling two products: 1) AI output tokens; 2) AI workflow processing capacity, the latter of which can be measured by GPU rental prices. However, due to intensifying market competition, output token prices have collapsed significantly (as measured by the LLM Expenditure Index). Therefore, as token products become increasingly commoditized, it will be difficult to achieve profitability—this mainly affects OpenAI and Anthropic, with many companies in their ecosystem chains also impacted.

AI adoption progress has also been disappointing. At present, it seems that enterprises adopting AI have not obtained the corresponding financial returns from AI applications—which is the “pain point” of AI trades. Thus, the AI bubble is likely to continue to deflate. At the moment, this process is still gradual and selective, but it may accelerate.

In summary, if the bullish scenarios imagined by the bulls occur, then the US stock market’s year-end rally would indeed be worth anticipating. However, from a fundamentals perspective, the probability of these bullish scenarios playing out is not high. Therefore, the current sell-off is likely to persist and may further deteriorate with the accelerating deflation of the AI bubble.

The key question is whether this could be the beginning of the next bear market. If high inflation forces the Federal Reserve to invert the yield curve, triggering a recession and a reduction in AI capital expenditures, then the answer to that question would be yes.