January is a time to reflect and look forward to the year ahead. From market lows way back in the fall of 2022 when headlines exclaimed “the 60-40 portfolio is dead” through the end of 2025, the AI unveiling and capital investment bonanza that followed has elevated markets (and the 60-40 portfolio) higher than anticipated just three short years ago.

Our sense is the AI surge and broader market performance may see some moderation this year, especially if history is a guide. In this quarterly letter, we’ll examine challenges and opportunities facing investors, including upside and downside scenarios for AI stocks and the broader economy.

AI: Bubble or Bonanza?

The surge in AI-related stocks is fueling a debate on what could pop a potential bubble in the tech sector. Some bears point to so-called circular financing, where company A invests in company B, and then company B turns around and uses this cash to buy company A’s products. This type of complex vendor financing could be hitting the gas on the AI buildout now but could also slam on the brakes if demand falters.

Separately, history suggests that “hype cycles” such as the dot-com boom tend to overshoot. However, if AI stocks are in a hype cycle now, historical patterns also suggest that it may be difficult to pin down the inflection point when growth turns to decline. We have some concerns for companies highly concentrated in the AI data center buildout, compared to more diversified tech or industrial companies that may better withstand a slowdown in AI growth.

Turning to a more bullish view, we may still be in the early innings of a tech wave where AI tools drive significant economic growth through increased productivity. What’s more, we’re hearing from companies that they are struggling to build AI data centers fast enough, implying healthy underlying demand.

We’re also seeing measures of investor sentiment that, while above long-term averages, are well below prior tech booms, suggesting the downside could be less than in prior cycles. In sum, we believe it’s important to have some exposure to AI companies, but as active managers we are constantly re-evaluating downside risk and upside potential.

Recession or Growth?

While AI-related spending is supporting the tech sector and data center construction, many investors are wondering if less favorable factors could tip the broader economy into a recession. The two most likely recession triggers in our view are potential increases in inflation, which is running hotter than the pre-Covid era, or unemployment, which has been climbing gradually since early 2023.

Despite these risks, recent policy changes are putting downward pressure on taxes and interest rates, creating an environment that may keep the economy humming while offsetting elevated inflation and job market strains. Data from the Federal Reserve Bank of New York suggests a 25% chance of a recession this year, which seems to support this more favorable scenario for the economy.

To be fair, there could be some external supply or demand shocks that change the picture for economic growth this year. The U.S. economy overcame surprising tariff policies in 2025, but 2026 could see other unexpected events that either help or hurt economic growth.

Positioning for the new year

Investing for the long term requires acting in the short term. While some investors consider reducing stock or bond exposures amid worries over an AI bubble and a potential recession, we continue to favor balanced portfolios that minimize cash and maintain exposure to both stocks and bonds.

Our base case anticipates modest expansions in both the economy and stock market this year. Our sense is equity performance could track earnings growth in the high, single-digit to low, double-digit range, though slightly lower investor sentiment may weigh on total returns.

Outside the U.S. we see opportunities for diversification into less expensive stocks, with a caveat that earnings growth tends to be lower abroad. A weaker U.S. dollar benefited international stocks in 2025, and we will continue to keep a close eye on currency movements as 2026 unfolds.  

Looking ahead, our ongoing rebalancing into bonds during the recent equity bull market gives us the option to take on more equity exposure if there is a domestic or international market correction. Speaking of bonds, we continue to favor high quality government and corporate securities, offering ~4-5% yields. While additional Fed rate cuts may lead to lower overall interest rates, we expect these issues to have positive real returns over the course of a cycle.

While investors continue to wrestle with questions about a potential AI bubble and a possible recession, we take a longer view and prefer a fully invested approach that avoids market timing. By owning the stocks and bonds of companies that are growing and gaining market share, we strive to compound wealth over time, while remaining ever mindful of your long-term goals and objectives.

Wishing you a prosperous and healthy New Year.   

Michael Bailey, CFA
Director of Research                                          

Michael Mussio, CFA, CFP®
President