As of this writing, the S&P 500 is about flat YTD in 2026. However, this is masking the underlying cyclical rotation in the market.
This rotation has created a significant performance disconnect amongst certain sectors and subsectors as investors grapple with overall market sentiment. So, today we want to explore what we at Cornerstone believe are some of the driving forces behind the early sentiment disconnect.
The first thing to tackle is the recent hot headline of whether the AI carnage in the software sector is raising more broad-based concerns about if AI’s impact will be bad for equities.
To help frame this, from a historical comparison standpoint, the infrastructure story of AI today parallels the massive buildouts required for national wireless networks in the 1990s and early 2000s.
At the time, only about 7% of Americans used a cell phone. We’re seeing parallels today with the AI build out, but with 2025 dollars and global scale.
From an investor standpoint back then, there were periods of shifting appetites between buying the carriers, the infrastructure companies, and the handset makers. There were times when investors favored one over the others, with the carriers being like buying armies and the infrastructure companies like buying bullets.
This analogy is parallel to what's happening with AI today. For example, think of the “Magnificent 7” as the armies, whereas chips, memory, power generation, commodities, and so on are the bullet makers (we’ve used “picks and shovels” for illustration of this concept in the past).
How does this sentiment apply today? We're seeing a shift, where investors are favoring the bullet makers. It’s clear in the significant share outperformance in energy, materials, commodities, Industrials, memory chip makers, and more. Money somewhat rotated out of the armies for the time being.
In advance of this shift, we began last year by being increasingly overweight in bullet makers.
For example, in our dividend growth model, current holdings like Corning, Caterpillar, Parker Hannifin, Cummins, American Electric Power, and Mueller are all big bullet maker winners.
Conversely, in our strategic growth strategy, being overweight companies like GE Vernova, GE Aerospace, Arista Networks, KLAC, and Lam Research are the types of bullet maker winners due to this rotational sentiment currently.
While we’re cognizant of this thematic shift, it’s important to recognize that history tells us the tides will shift again back to the armies as the payoff of artificial super intelligence matures and takes shape.
What do we mean? Well, we can see this being reflected already in the carnage taking place within the software sector that AI is and will continue to be productive.
Software tools are input costs for corporate America. In 2025, the total software spend in the U.S. was about $450 billion. Think of this number as the total addressable market for AI solely within the software world.
The investor concern for companies within this space is that if AI can deliver the same services for about half the cost, there's a huge payoff for corporate America. But it’s at the expense of those companies.
Using an exchange-traded fund as a proxy, you can see it in the performance. The iShares Expanded Tech-Software Sector ETF (IGV) has lost more than a quarter of its value in the last six months:
This level of damage is the direct result of massive institutional selling:
To us, this disruption is early proof of the potential AI payoff. There's less software services spend for the same or greater output.
The earnings of those software companies will be in jeopardy while the rest of corporate America realizes increased productivity that also then becomes disinflationary. If that’s the case, then AI may ultimately lead to significantly less inflation.
Interestingly, last week’s consumer price index report was the fourth in a row to come in below Wall Street expectations:
The continuing cooling of inflation provides the new Federal Reserve plenty of room to cut interest rates if core CPI continues to drift below 2.5%:
The disinflationary environment and continued earnings strength provide support for market strength in the back end of the year.
This brings us to the second foundational pillar we want to touch on today. That is, over the long run earnings and equities have a very tight correlation:
As we've been discussing this year, especially in the current environment, it's clear that profitable momentum is accelerating and broadening as we begin to realize the AI driven efficiency gains that are driving positive operating leverage for corporate America.
This acceleration is clearly reflected in the consensus S&P 500 12-month forward earnings growth forecast, which now stands at about 15%:
That's significantly higher than only a year ago, when we were at high single digits.
This year’s S&P 500 revenues are forecasted to rise a solid 7.3%, which means it’s clear margin expansion will be the biggest contributor to EPS growth. In fact, net margin profit for 2026 is now forecasted to hit a record 13.9%:
There’s reason to believe that margins have room to expand even further. As discussed last week, unit labor costs measure wages adjusted for productivity. They grew 4.9% in the third quarter, which was more than double the 1.9% long-term average:
We know labor costs are one of the biggest expenses for companies. But the third quarter figure was one of the lowest rates on record and in the bottom quartile.
This matters because history tells us that lower labor cost growth has a direct correlation to margin expansion. This fact is supportive of potentially even stronger 2026 earnings momentum than expected:
Tying this all together, these data points provide the explanation of why in 2026 the cyclical bullet making sectors like energy, materials, and industrials are leading the markets by significant margins.
In January alone, those 3 sectors rose 14.4%, 8.7%, and 6.6%, respectively. They lead our sector rankings currently:
These sectors in 2026 also mirrored FactSet’s latest 2026 consensus earnings forecast. Profit growth will be led by technology, materials, and industrials, and significantly higher growth rates than the rest of the S&P 500:
This clearly shows that AI isn’t lifting all boats anymore, like in 2025. The fundamentals and earnings growth are being shown by companies benefiting the most from AI infrastructure buildouts. It’s clearly where the smart money is flowing at the moment.
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*Daniel Milan owns Corning and Arista Networks personally.
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