The incredible rally continued last week, with more gains across the board and more new highs. In the end, the S&P 500 gained more than 10% in April, the second-best April ever (going back to 1950). As we noted at the beginning of April, we expected a surprise rally, but even we didn’t see this coming. But we aren’t complaining, either. 😉
Things Changed Quickly
Five weeks ago, worries were building that we were heading for a bear market. We pushed back against this narrative and noted many reasons to expect a rally. Well, stocks are now back to new highs, and we don’t think the rally is over yet.
We found 13 other times in history that the S&P 500 gained more than 10% in a month, and more often than not, better-than-average returns afterward were common. Yes, 1987 is in there, but up more than 10% six months later on average could bode well for a surprise summer rally.
‘Sell in May’ Is Here
Buckle up, as the trigger points for one of the most well-known investment axioms, “Sell in May and Go Away,” has arrived. This gets a ton of play in the media, as the six months starting in May are indeed the worst consecutive six months on the calendar historically. The S&P 500 has averaged only 2.1% over those six months and moved higher just under 66% of the time.
Let’s be clear: Up 2.1% might not sound like much, but it is still an increase. Also, we do not advocate making investing decisions based simply on the calendar, but it is worth being aware of this calendar effect, as you will hear a lot about it over the coming weeks.
It Hasn’t Worked Lately
This time a year ago, many were expecting the big rally in April to roll right back over and potentially turn into a bear market. Well, instead we saw the strongest “Sell in May” six-month rally in history. In fact, make that nine of the past 10 years stocks gained during this historically bearish period.
Taking this a step further, May, June, and July have been extremely strong lately.
Think about these stats:
- The S&P 500 in May has been higher 12 of the past 13 years.
- The S&P 500 in June has been higher nine of the past 10 years.
- The S&P 500 in July has been higher 11 years in a row.
It’s How You Start that Matters
It’s worth noting that if the year is positive going into these six months, the market does much better. And if the S&P 500 is up more than 4% for the year (like we are this year), the next six months go from an average return of 2.1% to 4.4%. The flipside is that some of the worst “Sell in May” periods in history took place after a bad start to the year.
The bottom line is that this bull market is alive and well, and we think it may continue for at least the rest of 2026.
The AI Wave Continues, and It’s a Big One
In our 2026 Outlook, we said we thought the artificial intelligence (AI) spending wave would be a strong one. Five months later, that picture hasn’t changed—if anything, it’s strengthened. AI continues to have a big impact on the economy, but the focus is still spending related to building out AI rather than AI providing a boost to productivity. That’s something we’ve yet to see, and we probably won’t get details on it until several years from now.
AI-related investment is surging on both the hardware and software side. Looking at hardware, investment spending on IT equipment rose at an annualized pace of 43% in Q1 and clocked in at a 31% annualized pace over the past five quarters. The 2010-24 annual pace was just 6%.
On the software side, investment spending rose at an annualized pace of 23% in Q1 and clocked in at a 15% annualized pace over the past five quarters. The 2010-24 annual pace was 9%.
These numbers are simply massive, and keep in mind that these are all adjusted for inflation. They’ve made a huge contribution to GDP growth recently. Across the past five quarters, real GDP growth averaged 2.0%. AI-related hardware (IT equipment) and software spending contributed 0.90 percentage points (pp) per quarter, or about 45%(!) of real GDP growth. (For perspective, consumption contributed an average of 1.36 pp per quarter, but consumption makes up 68% of the economy while AI-related investment spending makes up just under 5% of GDP.) Putting it in historical perspective, from 2001-24, IT equipment and software spending contributed on average 0.27 pp per quarter. Even during the internet boom (1995-2000), it only contributed an average of 0.68 pp per quarter to real GDP growth.
Looking ahead, it doesn’t seem like there’s going to be any letup, at least in the near-term. The big tech firms recently reported earnings, and they’re ramping up capex to even higher levels. When we wrote our 2026 Outlook, we estimated that these firms would spend a total of $515 billion on capex in 2026, up from almost $400 billion in 2025. That amounts to about 1.6% of GDP, which is staggering. The most recent updates take the 2026 capex estimate to a whopping $725 billion, which is about 2.3% of GDP. That’s over 4x the level of capex in 2023 (0.5% of GDP) and 7x the size of where it was in 2019 (0.3%). And the wave is still building—2027 is expected to be even higher.
What’s important to keep in mind here is that one company’s spending is another company’s revenue and profits. That’s the connection between all this spending and what we’re seeing in the stock market.
But Why Is Real GDP Growth Relatively Weak?
Real GDP grew just 2% annualized in Q1, below expectations for a 2.3% increase. This was a pickup from the weak Q4 pace of just 0.5%, but in line with the 2025 pace of 2%. The big bounce from Q4 2025 to Q1 2026 was not a surprise, as weakness from the government shutdown in Q4 reversed and boosted growth in Q1. One way to look past the shutdown impact is to average real GDP growth across the last two quarters. That gets you to a relatively weak 1.25%. That is a marked slowdown from the 2023-24 pace of 2.9% and also below the 2010-2019 trend of 2.4% annualized.
This seems strange given the AI-related investment boom, but the issue is that a lot of the equipment is imported (and also exempted from the post-Liberation Day tariffs), and so it doesn’t directly “contribute” to GDP in a strict sense, since only goods produced domestically contribute to GDP. The way GDP is calculated, the spending appears as part of investment but then gets canceled out by the adjustment for trade.
GDP growth can also be noisy because trade (“net exports,” or exports minus imports) and inventories are volatile. Excluding these gives us “real final demand,” a picture of domestic activity that combines household consumption, investment, and government spending.
Real demand rose at a robust annualized pace of 2.8% in Q1 thanks to the rebound in government spending. If we just focus on the private sector, real demand rose at a relatively healthy pace of 2.5%, and it’s averaged 2.4% annualized over the last five quarters. That’s not bad, but it’s slower than the 3.2% pace we saw across 2023-24 or the 3.0% trend from 2010-19.
Real final demand running below trend is essentially why GDP growth over the last five quarters has clocked in below trend, too. There are two big drivers here:
- Weak goods spending, which has run at an annualized pace of just 1.1%, well below the 2010-19 trend of 3.6% and the 2023-24 pace of 3.9%.
- Weak residential investment (housing), which has fallen at an annualized pace of almost 5% over the last five quarters, versus 4.6% across 2010-19 and 1.9% in 2023-24.
Goods spending can be volatile, especially as consumers pull back amid higher inflation. But housing is paying the biggest cost of higher inflation because of higher interest rates. Residential investment has now fallen in seven of the last eight quarters, and this weakness is likely to continue if interest rates remain on the high side.
AI Feeding Through to Inflation
Despite the energy crisis, arguably the most important macro story right now is the AI wave. But while AI demand continues to increase, supply can barely keep up, which is why we’re seeing massive AI-related investment that is more than offsetting weakness in other parts of the economy (like housing). However, the other side of this mismatch of supply and demand is inflation.
Amid AI-related bottlenecks, the Personal Consumption Expenditures Price Index (PCE) for computer software and accessories rose at an annualized pace of 59% in Q1. Prices for this category fell continuously over the past decade, but we’re seeing prices surge higher amid the AI boom.
Of course, AI-related bottlenecks are just one among many problems within the inflation data as inflation continues to creep higher.
We expect the AI wave to continue supporting the stock market, even as inflation remains elevated. Looking ahead, a Federal Reserve that is led by Kevin Warsh is likely to hold rates unchanged for the rest of the year. However, with inflation moving in the wrong direction, that means policy is actually getting more dovish. Couple that with rising fiscal deficits, and it means the Fed is likely to let the economy run hot, with nominal GDP growth continuing to clock in around 5% to 6%. For now, that’s actually a potential tailwind for stocks.
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