Mike Santoli: Why eye-popping earnings expectations have failed to lift the market for two months
Could earnings growth be too great for the stock market’s own good? A rude and perverse question to most fundamentally inclined investors, who love to extol corporate profits as the life-giving essence of bull markets. Profits, the denominator in most standard equity valuation constructs, substantiate the long-term rise in share prices, which outside of reporting seasons seems to happen for capricious reasons or none at all. The mantra heading into second-quarter results is that another display of stupendous growth of 24% over a year earlier makes equities appear quite reasonably priced. Indeed, the consensus S & P 500 earnings forecasts have been escalating with unusual velocity since the spring, at the same time the index itself has flattened out over the past two months, compressing the 12-month forward price/earnings multiple from near 22 to the current 20.7. .SPX YTD mountain S & P 500, YTD A secondary talking point is that even though the overwhelming volume of incremental growth is being driven by the semiconductor and other AI-capex beneficiaries, growth is “broadening out” to the majority of companies and sectors. These are facts, on paper. Are the profits sustainable? The questions mainly surround how a stock market should and will digest such an acceleration of earnings gains more typical of recoveries from recession while in the middle of a long-running economic expansion — with both average profit margins and the total profit share of U.S. GDP already at record-high levels. Veteran market strategist Jim Paulsen who now publishes research at Paulsen Perspectives, sets out the history of exorbitant earnings-growth phases: “S & P 500 EPS is more than 60% above its historic trendline – the highest S & P EPS has been relative to trendline during the post-war era!” This as the index’s longer-term valuation is also near the top of historical readings but has compressed from recent extremes. “Most bullish investors are primarily encouraged because rising earnings are fundamentally supporting higher stock prices,” Paulsen says. “Is there any reason to fear a rising stock market when its PE multiple remains unchanged or declines? Actually, there is! Historically, regardless of the stock market’s valuation, when prices and EPS have simultaneously risen this much above trendline averages, the future 1-year average performance of the stock market has proved disappointing.” The suggestion here is that investors generally resist the urge to extrapolate such a bottom-line bonanza indefinitely, wary that Corporate America could either be “over-earning” or front-loading the benefits of a business-investment boom whose costs will hit the books more slowly over time. For sure, if the principles of capitalism were fully in effect, very high profit margins ought to be competed down over time by new and existing businesses. This hasn’t happened at the index level in recent decades, though, as many sectors became “winner-take-most” arenas and high-return tech companies took a larger share of public-market capitalization. The current dynamics of the AI boom are creating complications to the long-running notion that corporate profitability in recent decades has become more resilient and of higher quality, generating generous free cash flows and meriting a higher valuation. This was a key argument used to bless historically high valuations: The S & P 500 has held above 20-times forward earnings two-thirds all months over the past six years, after decades in which such valuation heights were rare. Hyperscalers losing premium valuation We now have four “hyperscalers” accounting for 16% of the S & P 500 (Microsoft, Alphabet, Amazon and Meta) sacrificing essentially all of their free cash flow to build computing capacity. Semiconductor makers, now near an 18% weighting in the S & P 500, are taking in that money, exploiting shortages and rationing scarcity through soaring prices. MAGS YTD mountain Roundhill Magnificent Seven ETF, YTD The hyperscalers routinely carried premium valuations due to their effortless profitability and their perceived wide competitive moats. But all their valuations have come down toward or below the broad S & P 500. Semi companies sport lower valuations as traditionally cyclical businesses. So, this process in sum is acting as a restraint on the index multiple. Semi stocks, already down 15% as a group in three weeks, seem to require the big spenders to reaffirm their aggressive capex plans for 2027 and beyond. But if they do, can their shares regain their higher valuations? Bank of America equity strategist Savita Subramanian finds little too be concerned about in the broad earnings picture now forming: “Expectations are elevated, but we see no signs of earnings momentum rolling over: Tech and energy continued to drive estimates higher ahead of reporting, guidance and revision trends are near post-COVID highs, both ISM PMI surveys are in expansionary territory and early reporters started strong.” Still, while growth will become more pervasive, the median S & P 500 company is projected to show second-quarter EPS growth of 8%. Respectable, though the median S & P 500 is also up 8% this year, indicating that the market has recognized much of this improvement. Subramanian is also on alert for a further erosion in earnings quality. Beyond the relative lack of free cash flow, she notes recent help from the markup of large private AI stakes held by Amazon and Alphabet as lower-quality contributors to the bottom line. It could be that the sideways churn in the S & P 500 and cooling of tech performance in general since mid-May is the market’s way of drawing into a more neutral footing ahead of the results after Micron Technology has sold off dramatically since reporting stellar results a few weeks ago. Or was Micron a preview of the demanding setup? As always, the reactions to the results often tell us more than the numbers themselves.
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