Why are US stocks rallying despite Fed rate shock? Aswath Damodaran explains in the context of AI

US equities have held firm despite a sharp rise in bond yields because the market is being supported by an AI-led earnings surge, according to valuation expert Aswath Damodaran, who warned that the same trade has turned the market into a large bet on whether artificial intelligence can deliver the profits now being priced in.

In his latest blog post, Damodaran said September 2026 was one for the record books as the US 10-year Treasury yield jumped from 4.75% at the start of the month to 5.29% by the end. The 54 basis point increase ranked among the top 10% of monthly moves in 10-year yields seen between 1962 and 2026. Yet stocks held their ground, with the US market adding $2.5 trillion in market value during September. Almost $1.5 trillion of that gain came from technology stocks alone.

The resilience, according to Damodaran, is coming from earnings. He said US companies have reported higher-than-expected earnings in 2026, while expected earnings for 2027 and 2028 have also moved up. The rally, however, has been narrow. Technology, energy and materials have carried most of the market gains this year, while only about half of all companies are up for the year. In the third quarter, nearly 65% of listed stocks saw their prices fall.


Damodaran’s implied equity risk premium model shows the strain from higher rates. At the start of October, expected return on equities stood at 8.99%, while the equity risk premium fell to 3.70% over the 10-year Treasury yield of 5.29%. He said the premium has dropped below 4% for the first time this year, even as the expected return on stocks has risen from 8.41% at the start of 2026 to 8.99% by September-end.

The force behind this earnings surprise is AI capital expenditure. Damodaran said AI is now at the centre of the corporate story driving market resistance to higher rates. Hyperscalers such as Meta, Alphabet, Amazon and Microsoft are spending heavily on data centres and AI infrastructure. That spending hurts their free cash flows, but it becomes revenue for chipmakers, networking equipment firms, power companies and data-centre real estate developers. Nvidia and TSMC are among the clearest beneficiaries.

The scale of spending is large. Damodaran said capital expenditure at publicly traded US companies in the second quarter of 2026 was up $133.4 billion from the same quarter last year, a rise of almost 36%. The increase was concentrated in technology, communication services and consumer discretionary, where capex growth exceeded 50%.

The AI boom is also changing balance sheets. Across US stocks, book equity rose nearly 13% between the second quarter of 2025 and the second quarter of 2026, while total debt rose almost 8%. In dollar terms, book equity increased by $1.8 trillion and book debt by $1.9 trillion. Technology saw a much sharper increase, with book equity up almost 30% and total debt up about 18.8%.

Earnings have followed the capex boom. Aggregate net income at US companies rose from $511 billion to $692 billion in the first quarter of 2026, a 35% increase from the year-ago quarter. In the second quarter, earnings rose from $576 billion to $904 billion, a 57% increase. The gains were led by technology, financials and communication services, while healthcare, utilities and real estate lagged.

But Damodaran said investors should not confuse accounting earnings with free cash flow. Dividends are up about $43.3 billion and buybacks by $106.7 billion, but cash returns have not kept pace with earnings growth. S&P 500 companies returned only 63% of earnings to shareholders in the last twelve months, the lowest level since 2004.

The risk is that AI may fail to justify the money being spent. In the best case, AI builders earn returns above their cost of capital and become more capital-intensive but successful businesses. In the worst case, companies will face write-offs, stock price markdowns and, for those relying heavily on debt, distress and defaults. Damodaran said markets will likely react before accountants do, meaning investors waiting for write-offs before selling may be too late.

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For investors, he said there is no way to sit out the AI debate. They can go all in, follow market consensus, stay skeptical, or actively bet against the AI story. Damodaran said he is broadly staying with market consensus through holdings in major technology names, while keeping new money largely in short-term Treasuries and cash.

Disclosure: This article has been written by Podishetti Akash, who is not a SEBI-registered Research Analyst or an Investment Adviser. Podishetti Akash and his ‘relative(s)’ (as defined under Section 2(77) of the Companies Act, 2013) do not hold any financial interest in the companies mentioned in this article as of the date of publication. The views/recommendations mentioned in this article, wherever applicable, are those of the respective SEBI-registered Research Analyst/brokerage and have been reproduced/reported with due attribution. They should not be construed as the views or recommendations of The Economic Times Digital or the journalist. Readers are advised to consider the original research report and make their investment decisions based on their own assessment. Brokerage disclosures here.