There are some signs of economic stress emerging. Mortgage rates have reached 7.12%. Deeply distressed leveraged loans have reached the highest levels since the pandemic. And I want to take the time to do a deep dive into what sectors and stocks did well, which did not, and why. So, we have to admit that investing in the S&P no longer provides diversification. It's mostly all one trade: AI. And to be perfectly frank, that makes me nervous. I want to review a bunch of questions I've received about what to do to diversify away from AI. Answering this question is more difficult than it first appears. Let me lay out the nature of the problem. Now, let's dig deeper.
Hi, this is Steve Eisman and this is another edition of the weekly wrap. This is for the week ending Friday, October 9, but recorded Thursday night, October 8th. I just want to repeat an announcement about a change we made this week. Monday and Friday episodes are available to premium Substack subscribers earlier. The Monday interviews are released for those subscribers at 12:00 p.m. Eastern Standard Time every Sunday, and the Friday wrap is released at 12:00 p.m. Eastern Standard Time every Friday. The Monday and Friday episodes will be available on YouTube and all audio channels at the usual times: Monday at noon and Friday at 4:15 p.m. On this week's wrap, we will discuss the war in Iran, interest rates and oil prices, a snapshot of the economy today with key weaknesses perhaps emerging, an analysis in depth of the third quarter, why I covered FICO and sold my long position in Glass House Brands, and one mailbag.
There wasn't any significant war news this week, but what is clear is that the only two variables for the market that matter on a day-to-day basis are movements in oil prices and the 10-year yield. On days when oil and rates are up, the market goes down and vice versa. Take for example Thursday. There were headlines that President Trump is no longer interested in a deal with Iran and is planning to resume bombing. As a result, oil prices climbed, the 10-year yield rose, and the market declined. I take this threat seriously, and I assume that if bombing does resume, it will occur right after the midterms. As I literally wrote this last sentence, President Trump stated that he would not start bombing Iran until after the midterms.
We're going to spend most of this wrap talking about the third quarter. But first, a few points. There are some signs of economic stress emerging. Mortgage rates have reached seven and a half percent, the highest level since 2023. Second, deeply distressed leveraged loans have reached the highest level since the pandemic. For example, the value of loans trading below 60 on the dollar rose to 65 billion from 40 billion a year ago. Loans trading below 80 cents reached 140 billion, a jump of 90% versus a year ago. The biggest concentration of distressed loans is in the technology sector at 39%, with software of course being a big chunk of that.
Moving on, France seems to be in trouble and I'm not referring to the riots that are currently taking place. In the sovereign debt world, France was viewed as a safe haven, no longer. French debt to GDP has reached 120%, a dangerous level, and French rates are marching higher. There is zero consensus on what to do. Marine Le Pen, for example, the candidate for president, wants to reduce the retirement age to 60 and that certainly won't help. By contrast, US debt to GDP is at 125%. Now, the reason why France is in trouble and the US is not, at least not yet, is twofold. First, the US is the reserve currency of the world. And second, the entire global financial system functions on treasuries. The repo market only uses treasuries. When large institutions want to park money, they buy, you guessed it, treasuries. Until there is a serious alternative to treasuries, the US has the luxury of time. France does not. No one needs to own French sovereign debt.
So, the third quarter is over and I want to take the time this week to do a deep dive into what sectors and stocks did well, which did not, and why. Now, the big news for the quarter was, of course, continued war news, higher oil prices, much higher interest rates, the Fed raised rates, and of course, a continuing barrage of AI news. For the market, the most important news was probably the change in the 10-year yield, which during the quarter marched from 4.5% to 5.25%. Now, that is a very big move in a relatively short period of time. To what do I attribute this move? Several things. First, AI debt issuance this year is around 500 billion. That is large enough to have something of a crowding out effect on treasuries, which is actually a shocking statement, but true. Also, while the overall inflation news was relatively okay, the war caused oil prices to move higher. And as a result, in September, the Fed decided to raise rates for the first time in years as insurance against potential future inflation. The combination of AI debt issuance and the Fed raising rates caused the ten-year to move to its current high levels.
Thinking about higher rates is not an academic exercise. Higher rates means that federal debt costs will move higher. It hurts the housing market, which was already pretty bad. It hurts any corporation raising debt and that includes AI debt issuance. It hurts consumers when they borrow. At some point of higher rates, the economy breaks. What that point is, no one knows, but I'm getting convinced that we're getting closer.
Moving on. The S&P was up 2% in the third quarter and up 12% for the 9 months. Given all the crazy news of the quarter, that 2% is not bad at all. However, performance was very mixed. If you look at the Russell 1000 for example, only 47% of stocks are above their 200-day moving average, which means that 53% are basically below. The mixed performance supports something I've been saying for a long time. For most investors, it's best to just own the S&P 500 index and forget about it. Or as Donnie Brasco said, forget about it.
Although this quarter there was money to be made in trades like software and energy, the odds of getting those trades all correct is low and the odds of making the wrong trading decisions is high. This year, the more balanced approach was to own the S&P because AI capex was an overwhelming driver of market performance, which meant relying on smart trades in beaten-down groups was just not necessary.
Let me now add a caveat to my suggestion to just invest in the S&P. Now, until now, that advice has been spot on. However, in a sense the market has now become all one trade: AI. Nvidia's market cap at 5.5 plus trillion is over 8% of the S&P and larger than the following sectors: healthcare, consumer discretionary excluding Amazon, industrials, energy, utilities, real estate, and materials. That only leaves the rest of info tech, financials, and communications services. But let's look deeper into the nuances of the sectors. The info tech sector is now 40% of the S&P. No sector has ever gotten to this level. When you then add companies technically not tech that are techy like Google and Amazon, you get to over 50%. Now add the utility sector which is 3%, which is supplying the power, and various industrial companies involved in AI data center construction like Eaton or power generation like GEV and PWR, and you're probably north of 65%.
So, we have to admit that investing in the S&P no longer provides diversification. It's mostly all one trade. And to be perfectly frank, that makes me nervous.
Now, let's turn to the third quarter. I'm putting up a table on the screen showing the performance by sector for the quarter and for the nine months of 2026. Now, for those of you who can't see the screen because you're listening on just audio, let me read out the performance by sector. Energy, best performing sector, up 16.5% for the quarter and up 37% for the year. Second, info tech, up 7% for the quarter and 28% for the year. Now since info tech, as I said before, makes up 40% of the S&P, its performance is the principal reason for the quarter and 9-month performance for the overall market. Healthcare up 6% for the quarter and 9% for the year. Communication services up 3.5% for the quarter and up 3.9% for the year. Financials down 50 basis points for the quarter and down 2.5% for the year. Consumer staples down 2% for the quarter but up 4% for the year. Materials down 3% for the quarter but up 8% for the year. Consumer discretionary down 5% for the quarter and down 6% for the year. That's ugly. Real estate down 6% for the quarter and up 3% for the year. Industrials down 10% for the quarter but up 8% for the year. And the worst of all, utilities down 13% for the quarter and down 8% for the year.
Now, let's dig deeper. Energy. Now, this sector is the best performing sector of all the S&P sectors for both the quarter and the year. It's not complicated as to why. The war in Iran has caused oil prices to surge and traditional energy stocks, which make up most of the sector, are highly, highly sensitive to changes in oil prices. That's why large energy companies like Marathon and Phillips are up over 50% for the quarter. However, it's important to point out that the energy sector is very, very small as a percentage of the S&P. It amounts to only 3.4% of the S&P. Think about it this way. Yes, energy is up 37.4% during the first 9 months. Multiply 37.4% by 3.4% and you get 1.3%. So of the 11.8% S&P 500 performance for the first 9 months, energy has contributed 1.3% of that total performance. Not bad, but there is just no way to get around the fact that the energy sector is tiny.
Info tech this quarter witnessed a reversal of the tech narrative that was dominant prior to the third quarter. Now, during the first six months, investors flocked to hardware tech companies that were experiencing shortages because of the boom in AI capex spending. So, companies like Micron and SanDisk did really well. Other suppliers such as Arista, Cisco, and Dell did very well too. These were the best performing tech stocks. Now, the worst performing tech stocks for the six months were those suffering from the SaaS apocalypse narrative. And that narrative assumes that almost all software companies will be eliminated by AI, with cyber security being an important exception. And then, as sometimes occurs with narratives, it flipped. Suddenly the new narrative was maybe AI won't kill all software and a rally ensued. Some of the best performing tech stocks for the quarter were software and tech consulting companies. So Palantir was up 60%, Workday was up 56%, Cognizant was up 48%, Accenture, the consulting company, was up 47%, and Salesforce was up 46%. Now all five of these stocks were hurt by the SaaS apocalypse narrative and then flipped. That is also why some of the best hardware stories did poorly during the third quarter. Investors reallocated viciously such that Western Digital, one of the best performing stocks of the year, was down 29% in the third quarter. The worst performing tech stock in 3Q was FICO, a stock I have spoken about several times. It was down 50% during the third quarter. And I'll have a few more words to say about FICO in just a bit.
Moving on, healthcare. Not much to say here. Healthcare is viewed as a safety sector. Thus, when investors get nervous about the economy like they were nervous during the third quarter, healthcare tends to outperform.
Financials. Like info tech, financials experienced a narrative reversal in 3Q. During the first 6 months, the large banks and investment banks outperformed. The economy was good and the investment banking cycle was in overdrive. In the third quarter, the war fostered fears of a recession and the Fed raising rates in September drove those fears higher. Recession fears create rising credit cost fears. And bank investors hate nothing more than rising credit costs. That's why Goldman and Morgan Stanley and a bunch of regional banks were all down over 10% during the quarter. Now, 10% does not sound so bad, but it's deceptive. The large banks had a sharp run-up from June 30th till July 15th. From that peak, they are down over 20%. Today, Goldman, for example, which had been a strong performer, is flat on the year.
At the same time, when bank investors are running scared, they seek safety in quote-unquote recession-proof financials like the exchanges. And that is why this quarter NASDAQ, CME, and ICE were all up 17 to 24%. Now, I'd also point out that lowly PayPal, poor PayPal, was up 22% in the third quarter. The company received an unsolicited bid at $60. Insanely, management rejected the offer as too low. I am bewildered by this decision. The payment space has become notoriously difficult. PayPal competes against giants like Apple Pay and Google Pay. Its franchise value has been obliterated. Management should have sold. The stock is now in the low 50s.
Let me add an important point to the performance of the banks in the third quarter. When the banks reported second quarter numbers in mid-July, they reported great results. And I pointed out in the weekly wrap of mid-July that bank stocks were at peak valuations. Goldman was valued at three times tangible book value and Morgan Stanley was at four times. I also pointed out that when bank stocks get to those kind of peak valuations, the only way to make money from there is for the investment banking cycle to remain really strong. Any hiccups and the stocks correct and that unfortunately is what has happened. At a recent conference, Brian Moynihan, the CEO of Bank of America, stated that higher interest rates have hurt fixed income trading. That was all investors needed to hear to sell off the group. So, what about now? I'm still not ready to buy bank stocks. If interest rates continue to march higher, fears of a recession will rise. Bank stocks never do well when investors are worried about a recession. I just think it's too early.
Moving on, consumer discretionary. This sector has had a tough, tough, tough year. Rising interest rates have hurt the entire housing sector, which is an important part of consumer discretionary. The housing market is locked and the building suppliers are suffering as well. That's why Home Depot was down 19% for the quarter. It's why Deckers Outdoor was down 21% and the war also hurt the cruise lines with Norwegian Cruise down 31% for the quarter.
Industrials. This sector is kind of a proxy play on AI. Many companies within the industrial sector are involved in AI construction or AI power supply. And that's why companies like GE Vernova and Quanta have done so well. But this quarter, the AI narrative took a bit of a break. As a result, two industrial AI narrative names like Generac and Vertiv were down almost 30%.
And finally, we end with utilities, a sector that usually screams safety. That safety patina, however, is no longer quite so impregnable. Utility stocks have also become quasi-AI plays as they are expanding to provide energy to AI data centers. The utility sector is spending around 250 billion in capex this year because of AI. Why was the utility sector down for the 9 months and for the year? A few reasons. Despite the new AI narrative, there is still a safety aspect to the sector. Many investors still buy utilities for their dividends. And with long-term rates rising, those dividends look less attractive. Also, a wave of affordability concerns hit the sector. Credit rating agencies like Fitch downgraded the North American utility sector outlook to deteriorating due to a ratepayer backlash. Regulators faced immense political pressure to cap customer bill increases, creating fear that utilities will not be able to fully or quickly recover their massive infrastructure costs. The combination of higher rates and ratepayer backlash caused stocks like NRG Energy, Edison, and PG&E to decline by more than 25% during the quarter.
Moving on, FICO and Glass House. An update on these two stocks. I gave this update at the end of last week in a Substack chat, but I thought I would repeat it here. With respect to FICO, I've been short a while. The stock is down 60% for the year. I think more bad news could still occur. However, when a stock goes down that much that quickly, the slightest good news can cause a counter rally. A lot of the bad news is now out. The better part of valor is to cover and so I did. With respect to Glass House, I sold my position after a steep decline in the stock followed by the CFO resigning. I'm not sure why the CFO is resigning even though the company maintains the resignation was planned. Why would a CFO plan to resign at the height of a growth story? Something is wrong. I found over the years that when I start to become obsessed with the daily movement of a stock, it's best to sell and perhaps come back later. So, I sold it.
No specific mailbag this week, but I want to review a bunch of questions I've received about what to do to diversify away from AI. Answering this question is more difficult than it first appears. Let me lay out the nature of the problem. Typically, an adviser would tell a client to put 60% of their money in equities and 40% in bonds. And that would constitute quote-unquote diversification, the magic thing that all investors want. Here's the problem. Today, info tech constitutes 40% of the S&P with most of that related to AI in one way or another. And as I said before, add companies that are not technically in info tech like Google and Amazon, and you reach 50%. The utility sector, which is 3% of the S&P, is also AI related. Then add companies in the industrial sector that help build AI data centers like Eaton and Rockwell. Then add industrial companies that supply the power like GE Vernova and Quanta. Then add financial companies that are financing AI like the large investment banks and the alternative asset managers. Add all that up and you're well, well, well north of 65% of the S&P. The only two sectors that are not involved with AI at all are staples and healthcare which add up to only 14% of the S&P. So in a sense the entire S&P is largely one trade: AI.
What about bonds? You say about 15% of existing corporate bonds are AI related but over 50% of this year's issuance is AI related. So bonds don't give quite the diversification that investors are looking for. My suggestion is that if you want to park money that will be immune to AI fluctuations, I would just buy short-term treasuries. The yield is decent and they are safe.
This week on October 7 on our premium subscription service, we interviewed Joseph Carlson, the host of the Joseph Carlson After Hours podcast. Is AI going to destroy planet Earth? We discuss where Joseph, a former software engineer, thinks AI is really impactful and where it is not.
Next Wednesday, October 14th on Premium, we will release an incredible interview with recurring guests Tom Gober and Gretchen Morgenson. We did a deep dive into the troubled insurance empire of Mark Walter, the owner of the LA Dodgers.
This week on October 5th on our free service, we interviewed Krishna Guha, the Fed watcher at Evercore. Krishna and I discussed recent moves by the Fed and what Kevin Warsh wants to change. We also discussed Treasury Secretary Scott Bessent's attempt to reduce long-term rates. And we went back in history and ranked past Fed chairs.
Next week on Monday, October 12th, we will post an interview with recurring guest Gary Marcus. Agents are not very reliable. The Hugging Face attack and turns out there were at least 11 of these. This will be released on Sunday, October 11th at noon for premium subscribers, but on Monday, October 12th at noon for free. Gary and I discuss all the crazy stuff going on in AI, including how seriously to take the claim that AI will end the world.
The best way to support The Real Eisman Playbook is to subscribe to Substack through steveisman.com. Subscriptions are free and we deeply appreciate your support. And that's the wrap.
This podcast is for informational purposes only and does not constitute investment advice. The host and guests may hold positions in stocks discussed. Opinions expressed are their own and not recommendations. Please do your own due diligence and consult a licensed financial adviser before making any investment decisions.
