GM. This is Milk Road Macro, the newsletter that charts the market like it’s Magellan with a Bloomberg Terminal.
Welcome back to another Milk Road Macro PRO report.
This is where I take a detailed deep dive into the most important factors across the global economy and risk asset markets. We’ll explore what’s happening right now and what might happen next.
We’ve seen a wobbly few months across risk asset markets recently.
But now it’s time to look ahead to 2026.
Will we see a “Goldilocks” economic regime emerge next year?
It looks like this is very possible…
In this edition, we will:
- Look in detail at exactly what has happened across markets in the past month.
- Assess the latest picture with the dollar and liquidity.
- Take a look at how financial conditions are shaping up.
- Consider where we are in the business cycle.
- Take a deep dive into what’s going on with the U.S. economy.
- And assess how investors are positioned and what this means.
This is a wide view of the most important factors driving markets.
As always, we have a lot of charts to get through (50+).
So, let’s get going…
SO, WHAT’S GOING ON IN MARKETS?
The U.S. stock market has continued to edge higher - with the S&P 500 poking up to a new all-time high.
Although, to be honest, the S&P 500 has been mostly flat and just chopping around for three months.
But it’s a particularly promising sign that market breadth remains relatively healthy - which means there is widespread participation across the market, not just a small number of names.
Below is an index showing whether 8 risk-sensitive sectors* are in a bullish or bearish trend.
(*Semiconductors, small-caps, transports, biotech, homebuilders, banks, retail, steel.)
We saw some weakness in market breadth during October and November.
But we currently see that 7 out of 8 sectors are in a bullish trend.
The current environment looks healthy to me and is likely set for a continued move higher.
There’s no sign of a sustained “breadth breakdown”, which typically precedes major market tops (yellow).
However, concerns about an “AI bubble” are still very much front and center.
These fears are now becoming so widespread that we’re getting close to the point where you’re taking a contrarian stance if you think we aren’t in an AI bubble.
Deutsche Bank polled its clients about what they believe are the biggest risks facing investors in 2026, and 57% included "Tech valuations plunge/AI enthusiasm wanes" as among their three biggest risks.
"We’ve never seen a single risk score so far ahead of the rest entering a new year, making it very clearly the dominant concern for 2026", said Deutsche Bank's Jim Reid.
I am hearing and reading ongoing comparisons between the current environment and the late ‘90s tech bubble - with people fearing that a “bubble burst” would be a major threat to the wider market and cause a severe market drawdown.
Just to reiterate the point that I made in a previous PRO report - we are objectively nowhere near a “1999-style tech bubble”.
Let’s look at price-to-earnings for U.S. tech companies relative to the broader market.
The chart below shows how potentially “overvalued” tech companies might be relative to other sectors.
We are currently almost bang-on the average for the past 30 years.
The forward price-to-earnings multiple for the top five largest U.S. stocks is somewhat elevated.
But still miles away from the levels of the late 1990s, and in fact it has fallen since 2020/2021.
And the gap between the top five stocks and the rest of the S&P 500 is near the narrowest it has been for the past decade.
If we look at current U.S. stock market price action relative to historical “mania bubbles” - it’s not even close.
In fact, as I outlined in the previous PRO report, the air has been let out of the “AI trade” in recent months.
The chart below from Morgan Stanley measures investor exposure to AI-linked stocks, relative to the overall market.
It’s currently near its lowest level since 2022.
I view this recent rotation out of the AI trade as healthy - and not at all “bubble-like” behavior.
I’m not necessarily saying this is a bargain stock market overall, or one that is “undervalued”.
And I’m not saying the AI trade can’t unwind further.
But, what I am saying is that we are nowhere near the late 1990s environment that many people are constantly comparing to.
If we are to see an actual late 1990s style mania (I’m not sure we will) - there’s still a long way to go yet.
I’m more than happy to call out a bubble when I see one - but we are simply not in a “late 1990s-style AI bubble” currently.
Sidenote: Don't miss what the AI giants are really working on. Our latest AI PRO Report is live now, and goes deep into how AI is accelerating its move into devices and robots.
There is a big crossover between a lot of these “AI-linked” names and more speculative, more volatile, “retail favorite” stocks.
And we see BUZZ (an ETF including the hottest “retail” stocks based on online sentiment) has been smashed lower in recent months.
If we look at BUZZ relative to the S&P 500 (BUZZ/SPX - a measure of “appetite for speculation"), it hasn’t yet recovered from the speculation smash that occurred in October and November.
And as I’ve also previously outlined - this speculative bucket is the same bucket that bitcoin lives in, in the eyes of the market.
Bitcoin is a highly speculative, highly volatile, “retail sentiment-driven” asset.
I see some people comparing bitcoin to the S&P 500 or Nasdaq, and pointing to the current divergence as bitcoin lags the major stock indices.
But in my view, this is not comparing “like for like” - BUZZ/SPX (or something similar) is the correct stock market proxy for bitcoin.
In this sense, it is not surprising that bitcoin remains subdued.
It’s probably trading roughly where it should be.
It’s difficult to know for certain if bitcoin has “decoupled from the stock market to the downside” unless/until it clearly diverges away from the more speculative elements of the stock market.
What has been performing well recently are the “boring parts of the market”.
Traditional cyclical stocks like small-caps, transports and industrials, among others, have been outperforming in a way that they haven’t done so for a number of years.
These sectors are heavily tied to economic strength and so this is a healthy sign in terms of the wider business cycle (we’ll get into this later) and not what you would expect to see near a major risk asset top.
Market leadership is clearly “broadening”, at least for now.
Whether you want to call it an “economic reacceleration” or a “business cycle expansion” - it looks like investors are hopeful of a strong U.S. economic rebound heading into 2026 and are rotating into more cyclical sectors that have underperformed mega-cap stocks for years.
This might be a very important shift to bear in mind as we head into 2026.
Another factor worth considering is that “more boring” sectors that are not strictly “AI-linked” could actually benefit a lot from the extra growth and productivity boost powered by new AI tools.
For 15 years, Ed Yardeni, of Yardeni Research, has been a prominent Wall Street cheerleader for the tech sector and more recently the “Magnificent 7”, at the expense of the “other 493” names in the S&P 500.
And he’s been right.
But now, for the first time since 2010, his tone has changed.
He recommends dialing down exposure to tech, and instead going overweight financials, industrials and healthcare - sectors he believes will benefit most from the AI boom.
He wrote:
"Our thesis is that in 2026, competition will slow the growth of the Mag-7s' earnings, while the AI services that they provide will boost the productivity and earnings growth of the Impressive-493. That's consistent with our Roaring 2020s scenario."
The analyst outlook for earnings growth is especially good for small caps (Russell 2000), after years of underperformance.
Although, to be fair, in many previous years we’ve seen high hopes for small-caps that have faded quickly.
But the Russell 2000 has started to perk up in recent months - and I think it will be very important to watch as we move into 2026, because it is essentially an “equity market barometer” of the U.S. economy.
The Russell is increasingly behaving like a clean expression of three things - stronger economic growth, easier Fed policy, and moderating inflation.
As an index packed with higher leveraged balance sheets and less pricing power than the large-cap S&P 500, it has a positive sensitivity to rate-cut expectations and growth, and a negative sensitivity to inflation.
The “economic reacceleration narrative” is driving the Russell 2000 trade - but it’s also a potential trap.
If growth shows up without inflation and the Fed stays in easing mode - small caps can keep running.
But if growth shows up and inflation follows, the Fed’s “risk management” cuts are done, and small caps will face larger headwinds.
Further, if growth doesn’t show up at all, earnings optimism fades and the Russell is hit hardest.
The conditions have to be just right - and we’ll look closer at the outlook for the U.S. economy later.
As I’ve been highlighting for some time now - the Russell 2000 price chart is almost identical to the Ethereum price chart over the past six years.
Both small-cap stocks and crypto assets need the perfect cocktail of economic conditions to perform well.
But in the past two or three months, Ethereum has been lagging behind the Russell 2000.
A sensible base case would be that Ethereum would catch up, should the Russell 2000 continue to break out and move strongly higher.
However, if it doesn’t - this would be a big red flag for the crypto world.
All previous major Russell 2000 break-outs (2020/2021, 2017 and 2013) coincided with crypto “frenzy phases”.
THE DOLLAR AND LIQUIDITY
As always, the dollar is a very important thing to watch.
The Dollar Index (DXY) has continued to weaken over the past six weeks - which can be considered “liquidity-positive” and is generally good news for risk assets.
When the dollar strengthens, it tightens financial conditions in the U.S. and saps liquidity globally, squeezing the global economy (more than 70% of world trade is denominated in dollars and more than 70% of global debt is denominated in dollars).
But the opposite happens when it weakens.
Here’s an updated view of our DXY rate of change (inverted) chart, overlaid with the S&P 500.
And bitcoin.
You can see how the strengthening dollar became a drag on risk asset prices through late 2025.
But this could be changing if the dollar continues to weaken from here - although the positive effects of a weakening dollar for risk assets are often lagged by roughly two or three months.
Looking specifically at the outlook for the dollar, there is now a new bearish factor to take into account.
The Federal Reserve has now begun to expand its balance sheet again for the first time since 2022 - buying relatively small amounts of Treasury bills in what it has labeled “Reserve Management Purchases”.
This is a complicated and nerdy subject - but if you’d like to learn more about what this is and why it is happening, I wrote a detailed two-part series here and here.
The short story is that I wouldn’t personally consider this balance sheet expansion to be “Quantitative Easing” in the traditional sense, in terms of any measurable direct stimulative effects on risk asset markets.
However, it is “liquidity positive”.
We can measure total “Federal Reserve Liquidity” by taking into account all the “liquidity altering” components of the Federal Reserve and creating a “Net Fed Liquidity” chart.
This dropped fairly drastically in late 2025 (as the Treasury General Account was rebuilt following the new debt ceiling deal in the summer of 2025 - more details on this here).
But it’s now moving higher again - and will continue to generally move moderately higher in 2026 as the Fed continues with “Reserve Management Purchases”.
It won’t be blasting off to the moon - but it will likely modestly increase.
This modestly increasing Fed Liquidity is likely to be a bearish factor for the dollar, on the margin.
So, the Fed’s “Reserve Management Purchases” will be a small and slow, but steady, headwind for the dollar (DXY).
A much larger bearish factor for the dollar would be if Fed rate cut expectations for 2026 increase (currently roughly 2 or 3 cuts are expected).
Many other global central banks are projected to slow rate cuts, if not stop altogether - and maybe even hike rates in 2026.
So, if expectations for Fed rate cuts increase, the dollar (DXY) would likely see a meaningful shift lower.
However, if it becomes apparent that the Fed might be done with rate cuts - the dollar might strengthen meaningfully.
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WHAT’S LEFT INSIDE? 👀
- How financial conditions are shaping up.
- Where we are in the business cycle.
- Why we could be on the verge of a “Goldilocks” economic regime.
- How investors are currently positioned and what this means looking ahead.
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