September is often the worst month of the year for stocks, and yet the S&P 500 ignored its critics and finished the month just 0.5% lower. But the headline masked what was happening beneath the surface. Information Technology (+4.4%) and Communication Services (+4.3%) accounted for the bulk of the gains, while Financials fell 7.3% and the S&P 500 Equal Weight Index lost 5.0%. A near perfect example of how U.S. stocks can still hit all-time highs while not all is calm beneath the surface.
Potomac’s CIO Dan Russo has been highlighting deteriorating market breadth for several weeks now (please see Ep. 91 | Dangerously Deepening Divergences for more insights).
Figure 1. Market Breadth Declined Markedly in September
S&P 500 Cumulative Advance/Decline Line
Sources: Standard & Poor’s, Norgate, and Potomac. Data as of October 6, 2026.
This type of divergence brings to mind Marty Zweig’s adage, “Don’t fight the Fed.” The author of Winning on Wall Street long emphasized that the direction of interest rates can exert a major influence on stocks. In the case of Financials, that relationship has been visible as the sector has weakened alongside a flattening yield curve.
Figure 2. Financials Have Underperformed as the Yield Curve Flattened
S&P 500 Financials Relative to the S&P 500 vs. the 2s10s Spread
Sources: Standard & Poor’s, Bloomberg L.P., and Potomac. Data as of October 6, 2026. Note 1: S&P 500 data are indexed so 12/31/2025 =100. Note 2: The 2s10s spread is the 10-year U.S. Treasury yield minus the 2-Year U.S. Treasury yield.
A similar trend can be seen in the Technology space, where a wide divergence has formed between companies with strong earnings and free cash flow and non-profitable technology companies that are more dependent on the price and availability of external capital as bond yields have surged. This has been a rapid turnabout for non-profitable tech, which was up roughly 55% year to date in early June and is now roughly flat. The Magnificent Seven, on the other hand, are back in vogue.
Figure 3. Non-Profitable Tech Stocks Have Quickly Unwound YTD Gains
Goldman Sachs Non-Profitable Tech Basket vs Mag 7 Year-to-Date Returns
Sources: Bloomberg L.P. and Potomac. Data as of October 6, 2026. Note: Goldman Sachs Non-Profitable Tech Basket includes U.S.-listed, loss-making companies in innovative and new-economy industries across multiple sectors and the Magnificent 7 consists of Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla.
With this concept in mind, we investigated how markets have performed during previous Fed tightening cycles when market breadth was weakening but growth metrics such as the Institute for Supply Management’s (ISM) Manufacturing Index remained in expansion.
Of the 12 tightening cycles in our study, only six met those criteria.
Across those six cycles, the median S&P 500 drawdown between the start of Fed tightening and the eventual bottom in market breadth was 14.3%. In other words, meaningful market weakness has been typical when the Fed is tightening, breadth is deteriorating, and economic growth remains resilient.
But the outcomes were far from uniform. Three of the six cycles (1965-1966, 1972-1974, and 2022-2023) developed into bear markets with maximum drawdowns of more than 20%. The other three experienced much shallower declines of roughly 7% to 9%.
Figure 4. S&P 500 Max Drawdowns and Returns After Market Breadth Bottom
Sources: Blinder (2023), Standard & Poor’s, Bloomberg L.P., and Potomac. Data as of July 2023. Note 1: The months to bottom uses the difference between the month the Fed started tightening and the actual day of the bottom in S&P 500 market breadth. Investors cannot invest in an index directly. Past performance does not guarantee future results.
What appears to separate those outcomes is the strength of the inflation shock. The three bear-market episodes experienced materially larger inflation shocks while economic growth remained resilient. While counterintuitive, when inflation remains problematic while growth stays firm, the Fed may be less inclined to respond to market weakness.
The current environment shares part of that setup. Growth remains resilient with third quarter real GDP growth tracking at roughly 3.7% according to the Atlanta Fed, bond yields have risen, and market breadth has deteriorated. Those conditions bear watching.
The key difference thus far is inflation. We measure the inflation shock as the increase from headline CPI inflation 12 months before the start of Fed tightening to the highest inflation rate reached through the eventual breadth bottom. Using that framework, the current inflation shock to date has been roughly 1.2 percentage points versus an average of about 5.1 percentage points across the three historical bear-market episodes.
That suggests that the current backdrop may be more aligned with a potential market pullback or correction than a new bear market.
Figure 5. Fed Tightening Cycles and Max Drawdowns Before Breadth Bottom
Sources: Blinder (2023), Standard & Poor’s, Bureau of Labor Statistics, Bloomberg L.P., and Potomac. Data as of October 6, 2026. Note 1: The months to bottom uses the difference between the month the Fed started tightening and the actual day of the bottom in S&P 500 market breadth. Note 2: Full inflation shock is the increase from headline CPI inflation 12 months before Fed tightening began to the highest CPI inflation rate reached through the eventual breadth bottom. Investors cannot invest in an index directly. Past performance does not guarantee future results.
There is also an encouraging side to the story. As figure 4 shows, once breadth finally bottomed in the six expansionary tightening cycles, subsequent S&P 500 returns were strong with a median gain of 28.8% one year later. All six cycles produced a positive return over the following 12 months.
Of course, investors do not know when breadth is bottoming in real time, but a sustained improvement in breadth could provide an important indication that the pressure is beginning to ease.
For now, history argues for caution despite new all-time highs with Fed tightening and weak breadth raising the risk of a market pullback or correction. However, the inflation shock so far has been considerably more modest than in the historical episodes that developed into the three bears. Ultimately, the ending of the story will probably depend on whether oil can find its way back to market.
