AI Rally Faces Twin Tests: Fed Decision and Big Tech Earnings Anchor Pivotal Wednesday

Good Morning Investors,

The S&P 500 continues its remarkable run with the index up 8% year-to-date, though beneath the surface this remains an AI-driven rally with fewer than 100 stocks making new 52-week highs. Tuesday's action reinforced the narrow leadership theme as markets positioned ahead of today's Fed decision and tonight's Meta and Microsoft earnings. With the VIX at just 15 signaling potential complacency and margin debt reaching levels not seen since the 2000 and 2008 peaks as a percentage of GDP, investors are walking a tightrope between opportunity and risk.

The earnings story continues to validate our AI infrastructure thesis, with 168 S&P 500 companies now reported and blended earnings growth of 4.5% year-over-year - 171 basis points above expectations. More telling is the market's harsh judgment: beats are rewarded with an average 1.1% price move while misses face brutal 5.2% punishment, the worst penalty since Q1 2017. This binary response reflects the high stakes nature of the current environment where execution matters more than ever.

Stock futures inched higher Wednesday morning as investors positioned for the day's twin catalysts. S&P 500 ($SPY ( ▼ 0.44% )) futures gained marginally while Nasdaq-100 ($QQQ ( ▼ 0.29% )) futures advanced 0.1%. Dow Jones Industrial Average ($DIA ( ▼ 0.78% )) futures slipped 9 points, reflecting measured caution ahead of the Fed decision.

Tuesday's session marked the first break in the market's historic run, with the S&P 500 falling 0.3% to end its six-day streak of record closes. The Nasdaq dropped 0.4% while the Dow declined 0.5%, weighed down by uncertainty around China trade talks as U.S. negotiators ended discussions without securing a tariff pause extension.

The measured positioning reflects a market in wait-and-see mode ahead of today's twin catalysts: the Fed's 2 PM decision and tonight's heavyweight earnings from Meta and Microsoft. While Fed funds futures price a 98% probability of unchanged rates, Chair Powell's press conference guidance on September cuts will matter more than today's decision itself.

Tuesday's action highlighted the extreme concentration driving this year's gains. The Magnificent 7's dominance has shifted market dynamics, with Microsoft ($MSFT ( ▼ 0.59% )) approaching a $4 trillion market cap while Apple's ($AAPL ( ▼ 0.26% )) S&P weighting has fallen from 7.9% in 2023 to just 5.7% today. This reshuffling reflects the market's laser focus on AI monetization capabilities rather than traditional metrics.

The narrow breadth creates both opportunity and vulnerability. Companies demonstrating clear AI revenue pathways are being rewarded handsomely, while those without compelling AI narratives face investor exodus. Tonight's reports from Meta ($META ( ▼ 0.2% )) and Microsoft will be crucial litmus tests for whether the AI capex spending can translate into meaningful revenue growth.

Amazon ($AMZN ( ▼ 0.39% )) emerges as my top pick for this week's earnings, positioned to benefit from the cloud infrastructure buildout that's driving competitor spending. I expect the Magnificent 7 to follow Alphabet's ($GOOGL ( ▲ 1.17% )) playbook and increase capex guidance, with particular interest in Zuckerberg's commentary on recent AI hiring initiatives.

Tuesday's results reinforced the binary nature of current market reactions. Starbucks shares climbed 4% in premarket trading after beating revenue expectations with third-quarter results of $9.46 billion versus $9.31 billion estimates, despite sixth consecutive quarterly same-store sales decline (-2%). Conversely, Visa fell 2% despite beating both earnings ($2.98 vs $2.85 expected) and revenue ($10.17 billion vs $9.84 billion expected), highlighting how elevated expectations have become.

The standout Tuesday story was Visa's insight into tariff-driven consumer behavior. CFO Chris Suh noted evidence of "pull forward" purchasing in categories anticipated to face higher tariffs, suggesting consumers are front-loading purchases ahead of potential price increases. This tactical behavior validates our thesis that systematic tariff implementation allows for business and consumer adaptation.

Booking Holdings demonstrated international strength with adjusted earnings of $55.40 per share versus $50.22 expected, as international bookings offset weak U.S. travel spending. The 16% revenue growth to $6.8 billion signals selective consumer strength in experience categories.

However, broader industrial signals remain concerning. JOLTS data showed continued labor market cooling with job openings declining, while the energy sector faces headwinds with Tesla's $4.3 billion battery deal with LG Energy Solution highlighting supply chain diversification away from Chinese suppliers due to tariff pressures.

Tuesday's conclusion of U.S.-China negotiations without a tariff pause extension introduced the first meaningful uncertainty in weeks. U.S. negotiators ended discussions with Beijing without securing the postponement of August 12th tariff increases that markets had hoped for. However, Treasury Secretary Scott Bessent's characterization of talks as "very constructive" suggests the door remains open, with the final decision resting with President Trump.

This represents a tactical pause rather than strategic failure. The Japan trade deal's completion (auto tariffs cut from 27.5% to 15% with $550 billion in US investment pledges) demonstrates the administration's systematic approach produces workable outcomes. The EU framework of $600 billion in US investments and $750 billion in energy purchases over three years provides the template other nations will likely follow.

Importantly, we've moved past peak tariff fear that gripped markets in April. While the China talks introduce near-term uncertainty, the established 15-20% baseline framework provides clarity for business planning. Each successive deal reduces tail risk and allows markets to focus on fundamental drivers rather than political theater.

Today's Fed meeting occurs against a backdrop of mixed signals that support my thesis for September easing. While the 98% market probability of unchanged rates makes the decision academic, Powell's forward guidance will be the key takeaway. The critical question is whether Fed governors Michelle Bowman and Christopher Waller, both having expressed desire to cut, will dissent - marking the first double governor dissent in decades.

My assessment remains that today represents a non-event that sets up September action. The economic data supports a dovish tilt: ADP private payrolls expected to rebound to 75,000 after June's -33,000 decline, GDP advance estimate of 2.4% showing solid but not overheating growth, and core PCE at 2.3% effectively at target when adjusted for housing distortions.

The Fed faces increasing political pressure from President Trump while navigating tariff-induced inflation pressures against underlying economic softening. Manufacturing PMI remaining in contraction territory and the measured labor market cooling shown in Tuesday's JOLTS data create room for policy recalibration without appearing reactive to political demands.

The current setup presents both exceptional opportunity and significant risk. Margin debt's fifth-largest two-month increase since 1998 signals investor enthusiasm has reached concerning levels. When margin debt exceeds 2000 and 2008 levels as a percentage of GDP, historical precedent suggests caution.

Yet the earnings momentum remains compelling. The 4.5% blended growth rate, significantly above expectations, validates the AI investment thesis. The harsh punishment for misses (5.2% average decline) reflects high stakes but also creates opportunities for companies that execute well.

The VIX at 15 suggests potential complacency in high-beta names, but this low volatility environment also provides favorable conditions for continued upside. The key is selectivity - focus on companies with clear AI monetization pathways and avoid those riding momentum without substance.

Tonight's Meta and Microsoft reports will be crucial tests. I expect both companies to increase capex guidance following Alphabet's lead, reinforcing the infrastructure buildout theme. Any sign of AI revenue acceleration or improved monetization metrics could unlock the next leg higher for the entire sector.

Today marks a pivotal moment for the AI rally's next phase. The Fed meeting should be a non-event that tees up September cuts, but tonight's earnings from Meta and Microsoft will determine whether the Magnificent 7 can justify their premium valuations. The narrow breadth and elevated margin debt levels demand selectivity, but the earnings momentum and reduced tariff uncertainty create a compelling backdrop for continued strength.

I maintain my constructive outlook while acknowledging the high-stakes nature of current positioning. The combination of AI infrastructure spending, dovish Fed positioning, and systematic trade policy creates opportunity for those who execute well. Tonight's results will separate the leaders from the laggards in this concentrated market environment.

The opportunities are abundant this week, but so are the risks. Focus on companies with clear AI revenue pathways and avoid those riding momentum without fundamental support.

Please feel free to reach out to me on LinkedIn or by email if you would like help navigating this market environment or have any planning-related questions.

Dan Sheehan

[email protected]

This newsletter is for informational purposes only and should not be considered as investment advice. Please consult with your financial advisor about your specific situation.