Markets give you a lot to react to and not much context. This monthly note is our attempt to provide some of that context. Thank you for reading.
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July 2026 in Review
Flip May’s leaderboard upside down and you roughly have June’s.
U.S. small company stocks (+7.3%) sit on top by a wide margin, meanwhile, some of the assets that led earlier this year sat at the bottom: commodities (-10.1%) and gold (-11.7%).
The small cap number deserves a second look. The S&P 500 fell 1.0% in June, so small caps beat large caps by more than 8% in a single month. At the halfway mark, U.S. small caps are up 24.0% on the year. That’s the best first half for the asset class since 1991, and the widest midyear lead over the S&P 500 since 2003. More on that below.
The rest of the equity picture was soft. The Nasdaq 100 (-0.1%), emerging markets (-0.2%), international developed markets (-0.2%), the broad U.S. market (-0.3%), and global stocks (-0.4%) all finished slightly lower. There was a cooldown in some of the mega-cap companies after the last couple of months, which pushed the Nasdaq and U.S. large cap indexes down. International stocks were hurt by a U.S. dollar that surged (+2.7%).
The Dow (+2.6%) was the large-cap exception. Keep in mind that it’s only 30 names and price-weighted. Caterpillar’s performance alone contributed +1.9%.
One month doesn’t change the bigger picture, though. The second quarter was the best quarter for most U.S. indexes since 2020, and almost every major equity asset class is up double digits year-to-date.
Bonds were fine. Municipals (+0.7%), international bonds (+0.4%), the U.S. aggregate (+0.3%), and corporates (+0.1%) all inched forward. Short-term yields rose after a more hawkish Federal Reserve meeting (more below), which kept a lid on returns.
The big losers were the war trades. Commodities gave back (-10.1%) as oil fell on news of a U.S.-Iran peace deal, though they remain up 24.0% on the year. Gold fell (-11.7%) into bear market territory (down more than 20% from its January high), and is now negative for 2026. Some of that is the fear premium coming out, some is a stronger dollar, and some is reportedly governments and oil producers selling gold reserves to raise cash.
Bitcoin was down big for the month (-20.2%), for the year (-33.4%), and over the past 12 months (-46.3%), in a stretch that included both a war (supposedly good for digital gold) and a risk-on equity market (supposedly also good for it).
Market Narratives
AI Fatigue and the “Lag-7”
The S&P 500’s June decline hides what happened underneath the surface. The index peaked at a record high on June 2, then fell about 1.7% through month-end. Over that same stretch, the equal-weight S&P 500 (which counts Apple the same as the 500th largest company) was up 1.4%. That’s not necessarily a market falling. That’s a market rotating away from its biggest names while the average stock is still rising.
Over the past few years, some of the biggest names with the most momentum picked up the moniker the Magnificent Seven, or Mag-7 for short: Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla. This (very short) period of underperformance has flipped the moniker from Mag-7 to the “Lag-7.” An ETF holding just those seven stocks (MAGS) finished the first half down 2.5%, while an ETF holding the large-cap market without them (XMAG) is up 15.6%.
That’s an 18-point gap between the market’s seven hottest companies and everything else, and most of it opened in June. The two had traveled roughly together into mid-May before the mega caps sold off while the rest of the market kept climbing. The rotation is happening even within technology. Semiconductor stocks hit a record high on June 22 while the mega-cap platforms and software names sold off.
So what changed? Call it AI fatigue. After two years of giving the hyperscalers the benefit of the doubt on hundreds of billions in AI infrastructure spending, investors have started asking when the payoff arrives. Token prices (essentially the wholesale cost of AI output) are falling, which could signal excess compute capacity. Chinese open-source models keep getting cheaper and more capable, and there are reports of major U.S. tech companies evaluating them as low-cost alternatives to the premium American models. And companies adopting AI agents are discovering that usage-based pricing can blow through budgets quickly—tokenmaxxing and the resulting tokenmaxxing hangover. To be fair, the label doesn’t fit all seven names equally. A couple of them have trailed all year for reasons that have little to do with AI.
I would note that falling token prices are lost pricing power for a handful of mega caps, but a falling input cost for everyone else. The cheaper and more efficient AI gets, the better the math works for the other 493 companies and the thousands of smaller businesses putting it to use.
Speaking of, let’s do a quick check-up on earnings. First-quarter earnings growth for the S&P 500 came in at 28% year-over-year, more than double the 13% analysts expected entering the year. And the growth is no longer confined to the top of the index (earnings data from FactSet, via Lord Abbett’s midyear outlook). Earnings for the other 493 companies have improved significantly, and small cap earnings, negative as recently as 2024, grew more than 15% in the first quarter. Forward earnings estimates for large, mid, and small cap indexes all hit record highs in late June.
Which brings me to where the money went.
Small Caps, Big Returns
For years, the small cap premium has been called into question. June was the answer.
Three things are likely driving the run. The first is valuation. Coming into 2026, small caps traded at their cheapest levels relative to large caps since the late 1990s, at around 18 times forward earnings while the biggest names traded far richer. You can’t time valuation gaps, but they do tend to eventually close, aka revert, to the mean.
The second is that the AI trade is finally trickling down. The buildout spending that flowed almost exclusively to mega-cap tech for two years is now reaching smaller suppliers, chipmakers, and infrastructure companies. Earnings growth estimates for the Russell 2000 have been revised up since January to +33% for 2026 and +17% for 2027.
The third driver is the one that best explains June specifically: oil and inflation. Small caps are the most inflation-sensitive corner of the market. Smaller companies carry more debt, more of it is floating rate, their costs are more exposed to energy prices, and they have less pricing power to pass increases along. That sensitivity has cut both ways this year. When oil spiked in March, the Russell 2000 was the first major index to fall into a correction. When the peace deal sent oil down nearly 20% in the back half of June, the same sensitivity worked in reverse, and small caps rallied hardest.
The payoff for owning small caps arrives in droves, unannounced, usually after a long stretch of looking wrong. The last time small caps led by this much at midyear (2003), the outperformance ran for the better part of a decade.
A New Hand at the Fed, and a Peace Deal
June packed two macro events into two weeks that would each headline a normal quarter.
First, Kevin Warsh chaired his first Federal Reserve meeting on June 17. Rates were held at 3.50% to 3.75%, as expected, but almost everything around the decision changed. The policy statement shrank from 341 words to 130. Forward guidance is gone. Warsh declined to submit his own rate projection, calling the practice unhelpful. No more Federal Open Mouth Committee.
Also, the committee’s projections flipped. In March, the median official expected a rate cut in 2026. Now the median points to a hike, with 9 of 18 officials penciling in at least one increase this year. Two-year Treasury yields jumped to their highest level in over a year, and futures markets no longer price any cuts in 2026.
The reason is inflation. May CPI came in at 4.2%, the hottest reading since April 2023, driven mostly by the energy spike from the Iran conflict. Core inflation was a milder 2.9%, which frames the Fed’s dilemma. How much of the headline number is a temporary war premium versus something else?
Then, days after the meeting, the war premium started answering the question itself. A U.S.-Iran peace deal was announced over the weekend of June 21, oil prices fell, and the whole inflation-hedge complex unwound. If energy prices stay here, the inflation prints that spooked the Fed should moderate on their own, which may take the rate-hike conversation off the table.
That’s the optimistic read. The cautious read is that a Fed openly discussing hikes, with a new chairman determined to prove his inflation-fighting credentials, is a different backdrop than the one investors priced in last December.
Closing Thoughts
We’re at the halfway point of 2026, which makes it a fair time to grade the forecasts. The headlines so far: a war in the Middle East and a peace deal to end it, gold falling into a bear market during that war, the largest IPO in history, a Fed that flipped from projecting cuts to projecting hikes, Bitcoin losing a third of its value, and small caps posting their best first half in 35 years. I read a lot of outlooks in January. None of them had any of that.
There has been leadership rotation. Commodities and gold carried the early months. Mega-cap tech owned April and May. The small cap dollar owned June.
Generally, there are positive conditions in place (i.e., a strong and growing economy, neutral to positive policy conditions, high margins and earnings growth, and a secular theme in artificial intelligence). Breadth in small caps and the S&P 493 make us breathe a bit easier than a narrow market. That said, elevated valuations will almost always make market moves amplified.
The second half does have open questions: whether the Fed actually hikes, whether inflation fades with oil, whether AI spending starts answering to the higher bar investors set for it in June.
From a practical standpoint, most portfolios have drifted from their targets, which makes midyear a natural checkpoint. Rebalancing keeps portfolios’ risk in alignment with your risk tolerance and financial goals. It’s a discipline that systemizes investing and reduces behavioral mistakes.
As always, please reach out if you’d like to talk through how any of this affects your specific situation.
Thank you for reading.
