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Wall Street’s expectations for company profit growth are rising at the fastest pace since the post-pandemic rebound, fuelling concern that an “earnings bubble” could be forming in the estimates that have underpinned the US stock market’s rally.
Analysts are now forecasting a 25 per cent increase in S&P 500 company earnings for the coming year, according to Bloomberg data, boosted by a resilient US economy and the AI boom.
However, just ahead of the second-quarter earnings season, some investors are growing concerned about the speed at which analysts’ estimates are rising. Some fear rising costs for AI companies, a drop in demand for the technology or a difficulty turning spending into profits could see earnings fall short.
Ben Inker, co-head of asset allocation at GMO, said forecasts for the next two years were “rising at an exceedingly high rate, nothing we have seen outside of a crisis recovery”. Consensus estimates for coming-year profits have risen by almost 20 per cent in six months, the biggest such jump since 2021.
“What we are due for, in the market, is the eventual realisation that they will not come true,” he added.
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Earnings expectations for chip companies and so-called hyperscalers have been driven by soaring demand for computing power.
Capital Economics analysts warned this week that “AI-related equity markets may be approaching a point where earnings expectations and capital expenditure assumptions become difficult to sustain” and a correction in these could “trigger a broad equity market pullback”.
Michel Lerner, head of UBS’s investment analytics platform HOLT, said “shares in the AI food chain are priced to maintain supernormal profits” and warned of an “earnings bubble” forming in the market.
While exceptional profits appear likely to keep being delivered in the immediate future, he said, “the likelihood of sustaining these levels of profitability and growth is incredibly low”.
Resilient corporate earnings have fuelled US stocks to record highs in recent weeks, with the blue-chip S&P 500 up 20 per cent over the past 12 months and the Nasdaq Composite up more than 25 per cent, including their strongest quarter in six years in the three months to June.
“We are in the middle of the strongest earnings upgrade cycle since the commodity supercycle,” said Arun Sai, senior multi-asset strategist at Pictet Asset Management, in reference to the China-driven natural resources boom of the mid-2000s.
The rapid rises in analysts’ expectations are helping keep stock market valuations — the multiple at which today’s share prices trade relative to future profits — in check, even as indices hit fresh highs. That, in turn, is easing some investors’ fears that a bubble may be forming.
US stocks are trading at about 20 times forward earnings expectations, according to Bloomberg data, putting the common measure of stocks’ expensiveness some way below levels reached last year or in the rebound from the 2020 Covid sell-off and well below the heights hit during the dotcom boom.
However, Sarah Ketterer, chief executive of Causeway Capital Management, said the low multiples could mean it was “not a good time to invest” if it indicates a stock is nearing its “peak earnings”.
Worries about the speed at which analysts are upping their forecasts come on top of other potential warning signs in financial markets, including a corporate rush to issue equity and debt, such as SpaceX’s record initial public offering and blockbuster debt deal.
Investors say an additional challenge to profitability could be a shift in market pricing on borrowing costs, with traders now expecting at least one quarter-point increase in US interest rates by the end of the year, compared with bets on two or three cuts at the start of this year.
There was a “very narrow margin of safety” on earnings now, said Kasper Elmgreen, chief investment officer for fixed income and equities at Nordea Asset Management.
“The debate is really about how long can we continue to see positive surprises, and are there some cracks now that expectations are so elevated?”
Data visualisation by Ray Douglas
