Controlled Flight Into Terrain: Navigating the Market Fog

Unbeknownst to investors, Wall Street entered a dense bank of fog on June 2, making it increasingly difficult for investors to remain on course. For an inexperienced pilot, inadvertently entering clouds and losing all outside visual references is terrifying. This is a condition known as instrument meteorological conditions, or IMC, which can be the most challenging situation for an inexperienced pilot.

The pilot's survival depends on resisting instinct and trusting the aircraft's instruments. Without a visible horizon, the body can create the false sensation that the airplane is flying straight and level when it may actually be entering a steep descending turn known as a "graveyard spiral." Turbulence can further intensify disorientation, allowing fear and panic to overwhelm sound decision-making.

The Pilot Debrief aviation podcast by Trevor "Hoover" Smith examines fatal accidents involving pilots who continued flying under visual flight rules into IMC. These accidents demonstrate how quickly spatial disorientation can become deadly. Research cited on the podcast has found that the average time from when an inexperienced pilot enters the clouds to a fatal crash can be less than three minutes. This circumstance is so common that the Federal Aviation Administration (FAA) has a term called "Controlled Flight Into Terrain" (CFIT), in which a perfectly functioning plane can be lost simply because the pilot no longer recognizes the airplane's true attitude or trajectory.

Investors can fall into a similar trap. When the market appears directionless, relying on emotions rather than fundamental and technical indicators can be devastating. An inexperienced investor may lose conviction and conclude that selling is the safest course. When headlines amplify potential risks, market "turbulence" can cause fear to spread rapidly, leading investors to abandon a sound strategy at precisely the wrong time.

The chart below illustrates the stock market's version of IMC since June 2. Over the past 90 days, the major indices have wandered within relatively narrow trading ranges. The S&P 600 as represented by the dark blue line initially appeared to rally in the fog with positive momentum. However, it encountered turbulence in mid-August as small-cap investors lost confidence and drove the index lower.

Meanwhile, the other major indices have continued to muddle through the fog, ending yesterday near where they began 90 days ago. During periods like this, investors must resist reacting to fear, remain focused on the underlying data, and trust the financial instruments that guide a disciplined long-term investment strategy.

We previously discussed the possibility that the stock market could enter a period of limited visibility, or "fog," during the third quarter, a historically weak period for stocks based on market records dating back to World War II.

Investors are now questioning whether stocks, particularly technology and artificial intelligence companies, have become overvalued or whether the recent lack of momentum is creating an attractive buying opportunity. Since June 2, uncertainty over valuations and the market's direction has produced a largely flat, directionless trading period.

What separates experienced pilots from inexperienced pilots during challenging conditions is how they respond to uncertainty. Experienced pilots understand that their instruments are more reliable than their instincts. They also recognize that poor weather is temporary and that clear skies may be above, ahead, or behind them.

Most importantly, they do not panic.

What instruments are experienced investors relying upon to determine their next move? They are examining the technical and fundamental data surrounding the US economy, corporate earnings, valuations, and market trends. Like pilots navigating unusual weather, experienced investors draw upon lessons learned from similar conditions while remaining focused on their primary responsibility: safely flying their airplane.

Investors navigating today's market fog should concentrate on two fundamental questions:

1. Are there clearer skies ahead? In other words, does the US economy remain stable, and can corporate America continue growing its revenues and earnings?

2. Are you flying your plane? What are your long-term financial goals, and how should your portfolios be positioned to help achieve them?

Are clear skies ahead?

Yesterday, The Wall Street Journal reported that corporate America, as represented by the S&P 500, recorded its strongest quarter of earnings growth since April 2021. In the article "Corporate America's Profits Are Booming and Signal More Good Times Ahead," Sarah Nassauer and Theo Francis reported that S&P 500 earnings per share jumped 53% in the second quarter from a year earlier, while sales climbed nearly 16%, according to LSEG data. Investment gains at Amazon and Alphabet boosted the totals, but even excluding those gains, earnings grew at their fastest pace since the fall of 2021. Just as encouraging, companies raising their profit guidance for the current quarter outnumbered those lowering it by nearly two to one, a reversal from a year ago.

The chart below, published with the article, illustrates the significant acceleration in corporate earnings during the second quarter.

Most importantly, the earnings expansion may not be over. Nassauer and Francis noted that improved full-year estimates came from a diverse set of companies spanning healthcare, laboratory services, and consumer staples, including McKesson, Charles River Laboratories, and Smucker.

The authors attributed the strong second-quarter results to what they called "a confluence of fortunate events," including booming artificial intelligence spending, federal spending, tariff refunds flowing back to companies, and consumers who keep spending with support from a strong stock market and high home values.

Together, stronger earnings, rising corporate guidance, and continued consumer spending suggest that corporate America may retain positive momentum as it moves into the second half of the year.

Are you flying your plane?

Pilots do not depart from their airport until they have a clear flight plan. They know every detail of their flight including altitude, air speed, weather conditions, and fuel burn. The most experienced pilots have a solid knowledge of their plane and engine that includes hours flown, airframe design, hydraulics, and electrical systems. Lastly and most importantly, they have a solid understanding of their instruments (avionics) to effectively navigate to their destination or alternate destination if necessary.

Investors also need to prepare their flight plan referred to as their Financial Plan. The proficient investor has a thorough understanding of their long-term financial goals and expectations. Their goals are outlined in detail with projected timelines vs general statements. To achieve their goals, their financial plan will outline minimum annualized investment returns, annual savings, tax liability, and risk planning. Like most pilots who want to continue flying, their financial plan does not end. There are future potential goals, maybe after retiring or selling their business, that will be considered with new sets of parameters.

Investors who enter periods of market turbulence with a plan typically remain calm because they know their long-term growth objectives. The past several years have provided excellent market conditions. For many investors, market returns have significantly exceeded the projected gains outlined in financial plans prepared years ago. The recent 90 days of flat trending has had minimal impact on portfolios for investors with expectations of realistic average annual returns to achieve their goals. For many, the year-to-date returns of the major indices have already exceeded the long-term return assumptions used in their financial plans.

What does this mean to me?

It remains to be seen how this market trends when exiting this flat trading period. The most challenging period for investors is during directionless market cycles. There is no indication whether the major indices will break down to new lows or rally to new highs.

Nevertheless, history offers real perspective. The US economy and stock market have recovered from every major crisis to date and gone on to new highs. This is true even after devastating events like the Great Depression, wars, hyperinflation, presidential assassinations, the dot-com bust, real estate busts, and massive disruption from global viral infections. The current period is quite calm compared to far more dramatic periods experienced in the past.

As discussed in previous UPdates, stock prices have remained largely unchanged while the revenues and earnings of many underlying companies have continued to grow. When earnings rise while share prices remain flat, valuations generally become more attractive. Given the strong second-quarter earnings results and expectations for continued growth, we believe the probability of an eventual move higher currently outweighs the risk of a sustained decline.

The catalyst for a new positive trend could be the midterm elections, improved access through the Strait of Hormuz, declining oil prices, progress toward resolving the conflict with Iran, or other developments that reduce investor uncertainty. Conversely, a deterioration in any of these areas could disappoint investors and trigger a market decline.

Nevertheless, the valuation clock continues to run. Each day that stock prices remain relatively unchanged while companies grow their earnings, free cash flow, and market share, those businesses become more attractively valued. Although short-term market movements remain unpredictable, our view is that the potential upside is greater than the downside and patient investors may ultimately be rewarded.

We welcome your thoughts on this UPdate. More importantly, if you do not have a well-designed financial plan, we are here to help. Our mission is to assist you and your family in defining your financial goals, developing a strategy to pursue them, and remaining on course through changing market conditions.

Up Capital Management is an SEC-registered investment adviser. The opinions expressed in this commentary are those of Up Capital Management as of the date of publication and are subject to change without notice. This material is provided for informational purposes only and does not constitute individualized investment, tax, or legal advice. Indexes referenced, including the S&P 500, S&P 400, S&P 600, Nasdaq Composite, and MSCI ACWI Ex USA, are unmanaged and cannot be invested in directly. Forward-looking statements involve risks and uncertainties, and actual results may differ materially. Past performance is not indicative of future results. Third-party data and articles referenced, including data from YCharts, LSEG, and The Wall Street Journal, are believed to be reliable but are not guaranteed for accuracy or completeness.

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