Why Record Profits Haven't Boosted the S&P 500 in Two Months
The S&P 500 has stagnated for two months despite 24% year-over-year earnings growth. The forward P/E multiple has fallen from 22 to 20.7, and Jim Paulsen warns that such historical outperformance of profits has often disappointed over the following 12 months.
The S&P 500 has been moving sideways for two months, even as analysts anticipate 24% year-over-year earnings growth for the second quarter. This disconnect has compressed the forward P/E multiple from 22 to 20.7, without reviving the index. This phenomenon raises questions for investors: how can such robust earnings leave the market unmoved?
A P/E Compression That Raises Questions
Since spring, S&P 500 earnings forecasts have been revised upward at an unusual pace. Yet the index has traded in a range, pushing the forward price-to-earnings ratio down from nearly 22 to 20.7. This move suggests that investors are unwilling to pay more for exceptional growth. In theory, higher earnings should support stock prices, but here the market seems to have already priced in this good news, or even anticipates a reversal.
The consensus remains that the profit growth, driven mainly by semiconductors and AI beneficiaries, justifies current valuations. But the question of the sustainability of these record margins arises. The share of profits in U.S. GDP has already reached historical highs, meaning companies are capturing an exceptionally high portion of national wealth. Historically, such levels have often been followed by normalization, either through rising costs (wages, raw materials) or increased competition.
The underlying economic mechanism is simple: in a market economy, abnormally high margins attract new entrants and encourage existing competitors to invest, which eventually erodes those margins. Additionally, regulators may take an interest in sectors where profits seem excessive. This cycle of mean reversion is well-documented and could explain the current caution among investors.
A veteran strategist, now at Paulsen Perspectives, has analyzed previous episodes of exceptional earnings growth. He notes that S&P 500 earnings are now 60% above their long-term historical trend, a gap not seen since the post-war period.
"Most investors are encouraged because rising earnings support stock prices, but historically, when prices and earnings have simultaneously exceeded the trend by this much, the average one-year performance has been disappointing," he warns. This observation aligns with the idea that markets are anticipating "over-earning" or a catch-up in costs related to corporate investments. In other words, the market may already be pricing in a normalization of earnings, which would explain the lack of enthusiasm despite flattering numbers.
The strategist also highlights that the long-term valuation of the S&P 500 remains near historical highs, even after the recent P/E compression. This means the market is not cheap, even with exceptional earnings. If earnings were to decline, the current multiple would become unsustainable, exposing investors to a potential correction.
Concentration of Growth Drivers
A frequent argument from bulls is that earnings growth is finally broadening beyond tech giants. While semiconductors and AI-related stocks continue to dominate most of the acceleration, other sectors are beginning to show signs of improvement. But this "diversification" remains to be confirmed in the coming quarters. In reality, a large portion of S&P 500 earnings growth comes from a small number of companies, particularly in the semiconductor sector, which benefits from AI-related demand. This concentration makes the market vulnerable to a downturn in these key sectors.
The market seems to be pricing in the risk that current record profit margins are not sustainable. In capitalist theory, very high margins attract competition and regulators, which eventually erodes them. The costs of massive investments in AI, for example, could weigh on future results. Companies must spend considerable sums on infrastructure, R&D, and talent, which reduces margins in the medium term. Additionally, rising interest rates, though stable recently, increase the cost of capital and could dampen investment.
Another factor to consider is the macroeconomic context. The U.S. economy has been expanding for several years, and earnings have already risen sharply. The question is whether this growth can continue at the same pace. Recent signals, such as slowing GDP growth or tensions in the labor market, suggest that the expansion could slow. In that case, earnings could be affected, especially since margins are already at record levels.
What This Means for Investors
The stagnation of the S&P 500 despite exceptional earnings sends a signal of caution. The forward P/E multiple of 20.7 remains high relative to historical averages, even after the compression. If earnings were to disappoint, the downside risk would be significant. Investors should therefore closely monitor the upcoming earnings season, especially company comments on their margin and investment outlook.
French investors exposed via ETFs like the S&P 500 PEA ETF should watch the upcoming earnings season. Confirmation that earnings growth is slowing or margins are contracting could justify a deeper consolidation. It is also important to diversify portfolios to reduce reliance on tech sectors and AI-related stocks, which could be most vulnerable in a downturn.
In conclusion, the market seems to be anticipating a normalization of earnings after an exceptional phase. Investors would do well not to be blinded by short-term growth numbers and to consider medium-term risks. Caution is warranted, and a disciplined approach to portfolio management is recommended.
