The U.S. stock market approaches October with lots to worry about
When the benchmark 10-year U.S. Treasury yields pierced five per cent on September 14, they reached their highest level since October 2023, and signalled a potential conflict between sovereign debt realities and a relentlessly optimistic equity market.
What makes the latest breakout particularly alarming is that it occurred despite active government efforts to suppress borrowing costs. The U.S. Treasury has accelerated its liquidity-supported debt buybacks, and the Federal Reserve (the Fed) continues its cautious stance on long-term inflation expectations. Despite this, bond vigilantes are pushing long-dated yields higher and taking control of the yield curve.
The last time U.S. Treasury yields broke out in early 2022, the S&P 500 went on to decline 18 per cent.
While today’s stock market is shrugging off rising discount rates, history says the divergence can’t endure indefinitely.
It’s fair to say today’s market harbours as many as five structural weak points. Indeed, even the eternally optimistic Ed Yardeni wrote recently,
“…the risks of a downturn have increased over the next three to six months, as reflected in the higher odds we assign to a bearish scenario.”
The first vulnerability stems from unprecedented investor leverage combined with record foreign exposure to U.S. stocks. U.S. margin debt has surged to historic highs in absolute terms as well as a percentage of market capitalisation, either leaving little room for downside error or potentially magnifying the impact of any setback.
Compounding this risk is the U.S. structural dependence on overseas capital. Foreign investors currently hold over US$37 trillion in U.S. corporate equities and Treasuries – a massive position equivalent to 115 per cent of U.S. Gross Domestic Product (GDP). If international investors trim U.S. allocations to capture higher yields at home or hedge against dollar volatility, the resulting capital flight could trigger a reassessment of asset prices.
Meanwhile, extreme market concentration has made index gains dangerously top-heavy. The top ten stocks in the S&P 500 account for about 38 per cent of the entire index’s value. A single mega-cap beneficiary of artificial intelligence (AI), Nvidia, commands a market capitalisation greater than five of the S&P 500’s eleven sectors combined.
This distortion also shows up in the Buffett Indicator, which measures total U.S. stock market capitalisation against national economic output. Prior to the 1929 crash, the ratio stood at 80 per cent. It stood at 147 per cent just before the dot-com bubble burst and 102 per cent right before the Global Financial Crisis (GFC). Today the ratio stands at an extraordinary 236 per cent. It’s worth adding the caveat that the ratio has been above the 2007 high since May 2013 and, in spite of this, the S&P 500 has rallied 365 per cent since then.
Elevated pricing today, however, comes as the U.S. economy shows unmistakable signs of softening. Steel production, rail freight carload volumes, and the Index of Industrial Production have all trended down in recent quarters.
And, of course, the pervasive exuberance surrounding AI-related market darlings must add to the fragility. Pessimists frequently note that enthusiasm for AI infrastructure has driven earnings multiples to levels that now require uninterrupted operational perfection. That will be a challenge given open-source and Chinese AI models offer good-enough, cheaper alternatives that could make generating a reasonable return for the frontier model providers impossible.
Finally, the return of protectionist trade policies and escalating tariff risks are introducing stagflationary headwinds anew. Reminiscent of the policy missteps surrounding the 1930 Smoot-Hawley Tariff Act, rising tariffs and global supply chain realignments continue to drive up input costs for U.S. corporations. These trade frictions complicate the central bank’s path toward monetary easing, as persistent price pressures limit the Federal Reserve’s ability to lower interest rates and cushion any stock market collapse.
October is traditionally the month when underlying financial stress manifests in heightened volatility and market corrections. With 10-year Treasuries now offering a guaranteed 5 per cent return, equity risk premiums have compressed to multi-decade lows. Stock markets can ignore the gravitational pull of high real interest rates only as long as corporate earnings growth outpaces the rising cost of capital.
As sovereign debt issuance climbs and financial conditions tighten, Wall Street might yet discover that 5 per cent bond yields are a superior option, not a temporary anomaly, and the catalyst for a fundamental market repricing, all at once.
Note: This article was written on 16/09/26.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.
Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
