Energy inflation, bond market selloff, and AI bubble all weigh on markets. Is the U.S. stock market's year-end rally in jeopardy?

Title context: Energy inflation, bond market selloff, and AI bubble all weigh on markets. Is the U.S. stock market's year-end rally in jeopardy? Text: Despite the recent pullback, the S&P 500 and Nasdaq 100 are still near record highs. In the bull camp's view, U.S. stocks are poised for a year-end rally, just as they have grown accustomed to for years. But some analysts believe the selloff in U.S. stocks is not overand may even have just begun. Bulls Still Betting on a Year-End Rally In the bulls' optimistic scenario, oil prices will somehow retreat before year-end, weakening market expectations for a Fed rate hike in 2027; the 10-year Treasury yield will somehow fall to 5% or below; and earnings growth momentum will persist, especially in the artificial intelligence (AI) trade. All of these factors would drive U.S. stocks to close the year at record highs, with the S&P 500 reaching or exceeding 8,000 points. There is no shortage of bulls on Wall Street either. As tech stocks have come under sustained pressure recently and weighed on investor sentiment, well-known Wall Street financial research firm The Kobeissi Letter has bucked the trend with a bullish call. In a newly released report, the firm noted that the U.S. equity benchmark index remains at high levels, but valuations have already "gone into winter." Analysts at The Kobeissi Letter argue that U.S. stocks are experiencing a "hidden bear market," which represents "one of the most significant opportunities in today's market." The firm's judgment is based mainly on valuation multiple compression. Energy inflation, Treasury yields, and rate-hike expectations have depressed the valuations the market is willing to pay; if these pressures ease and earnings continue to materialize, tech stocks led by the "Magnificent Seven" could see a strong valuation recovery. Even though the benchmark index is near record highs, The Kobeissi Letter believes that the stock valuations of some tech companies whose fundamentals far outpace the market benchmark already reflect a significant and unreasonable valuation discount. For example, Nvidia's stock price has risen 21% over the past 12 months, yet its price-to-earnings ratio has fallen 46%; its current forward P/E is about 24 times, close to the S&P 500's 22 times. Speaking of Nvidia, analysts said: "Even as earnings growth during this period was exceptionally strong and analyst expectations were revised upward, driving the stock up 21% and pushing its market cap firmly past the $5 trillion super threshold, the company's P/E ratio has fallen sharply by 46%." The firm also noted that the forward P/E of the S&P 500 Information Technology sector and that of the S&P 500 as a whole are now nearly identicala very rare occurrence, given that historically tech stocks have "almost always enjoyed a significant valuation premium relative to the broader market." As a result, the firm argues that this valuation compression has created a "hidden bear market" that is depressing the overall equity valuations of the world's largest tech giants. The firm's senior analyst team wrote: "If this backdrop ultimately stops being priced in by the market, it could catalyze another sharp rally in the S&P 500, where tech giants account for roughly 40% of the weight." They added: "If the breadth of the rally expands even slightly, buying pressure could increase rapidly." Goldman Sachs' flows team offers another bullish cluethe reopening of the corporate buyback window, year-end retail inflows, and post-election foreign buying could bring incremental demand for stocks that have been hit by valuation compression. For AI semiconductor assets that had previously been heavily underweighted, Goldman Sachs analysts emphasize that the new buying does not need to be very large to drive a significant price recovery. However, this support first applies to the overall market, and which companies ultimately receive large-scale inflows still depends on which companies can provide new evidence of earnings growth in this round of earnings reportswith AI computing-related semiconductor stocks and cloud computing leaders potentially holding an advantageous position. What both point to is that high-quality tech growth assets that can continue to deliver strong earnings are expected to benefit from both capital inflows and valuation recovery. The Selloff May Have Just Begun However, in the view of more cautious investors, the bullish scenario laid out by the bulls is very unlikely to materialize, and the current U.S. stock pullback is likely to evolve into a deeper correction. First, the energy-driven inflation shock may be difficult to eliminate. Analysts point out that the direct trigger for the selloff that began on October 14 was the market's reaction to a stronger-than-expected U.S. September CPI report. Given that core inflation remains elevated and is still rising, the Fed must stay vigilant, take proactive action, and tighten policy rates more aggressively, and the market has begun to price in the possibility of a more aggressive rate-hike cycle by the Fed in 2027. Surging energy prices are the biggest driver of intensifying U.S. inflation pressure. Although bulls hope oil prices will fall before year-end, the probability of that happening is very low. Because tensions in the Middle East are escalatingthe conflict has spread from the Strait of Hormuz to the vicinity of the Bab el-Mandeb Strait and could disrupt Middle Eastern oil supplies that have recently shown signs of recoveryand combined with the fact that global oil inventory buffers are being steadily depleted, all of this points to oil prices potentially rising further after the U.S. midterm elections, or even triggering an energy price shock similar to 1974. Clearly, this would force the Fed to adopt a more aggressive pace of rate hikes. Second, the global bond market selloff is likely to continue. Investors have already realized that Western countries are still continuing post-pandemic fiscal stimulus policies, but debt levels in the United States, France, Japan, and many other countries are now too high to be sustainable. Yet neither the United States nor any other affected country has the willingness to cut spending and raise taxes. Therefore, the global bond market selloff is very likely to persist. Long-term bonds are not even particularly worried about rising oil pricesthe rise in the U.S. 10-year Treasury yield is mainly driven by higher real yields. Breakeven inflation rates on inflation-protected bonds have remained stable, suggesting investors expect the energy shock to be temporary. Therefore, the risk is that bond investors may be underestimating the inflation caused by higher energy prices as well as sticky core inflation. This means that as inflation expectations rise, nominal yields could move even higher. In addition, the AI narrative that has supported U.S. stocks over the past few years appears to be showing signs of a bursting bubble. Concerns continue to build over the sustainability of AI financing deals and whether massive computing investment can ultimately generate enough revenue and cash flow. Compared with its June record high, the Philadelphia Semiconductor Index has fallen more than 20%, entering a bear market. As concerns over inflation pressure and fiscal conditions push Treasury yields higher, the era of cheap money experienced in the first nine months of this year is beginning to disappear. Luis Alvarado, co-head of global fixed income strategy at Wells Fargo Investment Institute, said that although investors were once excited about participating in the AI boom, market sentiment has begun to shift, and investors are now demanding higher risk compensation. Analysts point out that AI infrastructure construction is effectively selling two products: 1) AI output tokens; 2) AI workflow processing capacity, with the latter measurable through GPU rental prices. But due to intensifying market competition, output token prices have already collapsed sharply (as measured by the LLM spending index). Therefore, with token products becoming increasingly commoditized, achieving profitability will become difficult, and this mainly affects OpenAI and Anthropic, with ripple effects across multiple companies in the supply chains of these two AI giants. AI adoption progress is also less than ideal. For now, it appears that enterprises adopting AI are not obtaining corresponding financial returns from AI applicationsand this is precisely the "pain point" of the AI trade. Therefore, the bursting of the AI bubble is likely to continue to unfold. At present, this process is still gradual and selective, but it is very likely to accelerate. Overall, if the bullish scenario envisioned by the bulls materializes, then a year-end rally in U.S. stocks would indeed be worth looking forward to. But from a fundamental perspective, the probability of these bullish scenarios materializing is not high. Therefore, the current selloff is very likely to continue and worsen further as the AI bubble bursts faster. The key question is: could this mark the beginning of the next bear market? If high inflation forces the Fed to invert the yield curve and triggers a recession as well as a reduction in AI capital spending, then the answer to that question would be yes.