The Big Picture

Briefing.com Summary:

*The S&P 500 remains near record highs, but rising earnings expectations and falling valuations are raising eyebrows.

*Strong earnings growth faces tougher comparisons, while AI financing concerns and questions about investment returns are increasing investor skepticism.

*The market's sideways movement could signal a healthy valuation reset or growing doubts about the sustainability of earnings growth.

Is the stock market resilient, or is it nervous? Most pundits are quick to call it resilient, and it is easy to understand why.

Oil prices have risen appreciably. Interest rates have risen appreciably. Inflation has remained well above the Fed's 2.0% target. The Fed, expected earlier in the year to cut rates, has raised its policy rate. The war between Russia and Ukraine has worsened. Prediction markets suggest there is going to be a power shift in Congress following the midterm election. Bond vigilantes have started to make some noise in sovereign debt markets.

And yet the S&P 500 sits less than 3% away from the all-time high it reached on October 6.

Looked at from a different angle, the S&P 500 is also up just 0.3% since June 1, covering a period that has seen the forward 12-month EPS estimate increase 15% to $408.68.

That divergence tells an important story. Earnings expectations have been rising, but investors' willingness to pay for those earnings has been falling. The roughly 12% contraction in the forward P/E multiple is a telling indication that the market's problem isn't necessarily a lack of earnings growth but a lack of confidence in the durability of that growth.

Investors are struggling to reconcile strong earnings growth with growing risks to that growth, which is why the market seems to be going everywhere each day but getting nowhere.

Earnings Growth Meets Investor Skepticism

The fact of the matter is that earnings growth is strong. The S&P 500 has delivered double-digit earnings growth for eight consecutive quarters and is on track to report its third straight quarter of earnings growth above 25%, according to FactSet.

For the full year, S&P 500 earnings are projected to be up 33%. Calendar year 2027 earnings, though, are expected to be up "only" 15.8%.

That deceleration is a bit of a sticking point. First, because it is a deceleration. Second, because it involves the understanding that comparisons are going to be difficult. Third, because the AI growth story is starting to be called into question.

The latter has resulted from both supply and demand problems, only not in the traditional sense of supply and demand. The demand is there. The problem is that there are supply constraints for the components needed to meet the demand. Separately, it has been acknowledged that the financial capital needed to meet all the demand buildout is scarce. To be fair, it isn't scarce across the entire AI ecosystem, but the rising cost of capital is making providers of the capital more discerning about where it will be allocated.

Those concerns are running on one track. Running on a parallel track are concerns about the ability of some companies to pay back the debt they have taken on to fund their AI growth initiatives. Those concerns have contributed to pressure in credit markets, particularly for more leveraged AI-related companies, as investors reassess the risks associated with financing ambitious growth plans that are important to the economic growth outlook.

It is a strange juxtaposition, but what it shows is that the market is working harder to delineate winners and losers in the AI trade, whereas before it was a trade where all boats rose with the same tide.

The manner in which this growth issue unfolds is important, because a lot of the expected earnings growth is tied up in the expectation that spending for the AI buildout will continue to increase and that the returns on that investment will start showing up sooner rather than later.

The fallout seen of late in the AI trade is a case of de-risking by investors rethinking their previously rose-colored growth views. The consequence for the companies is that they are now in a position of having to prove their worth in each earnings report, unlike before when they were given every benefit of the growth doubt.

That change in thinking has been a contributing factor to the market's directional inertia.

Micron Is a Microcosm

The doubts about the ability to keep delivering on high earnings growth expectations are perhaps seen best in a stock like Micron (MU). This is a stock at the center of the AI buildout, yet it trades at just 5.6x FY27 (Aug) earnings, which is a huge discount to the market's multiple of 18.8x.

Micron operates in a highly cyclical industry. It faces a discount on that understanding alone, but the rub is that Micron's FY27 earnings are expected to increase 133% year-over-year, which is effectively multiples of what the S&P 500 is going to deliver over the comparable period.

No one is going to cry for Micron shareholders, seeing that the stock is up 210% year-to-date, but it is worth noting that Micron, with the hyper-charged earnings growth estimate for FY27, is down 29% from the high it reached in late June.

Price action like that is more than "consolidation." It suggests that investors are having their doubts about the ability of Micron to meet that expectation or that Micron's earnings are nearing a cyclical peak. The reasons why are twisted, from concerns about not having enough capacity to meet the demand to the industry readying itself to bring more capacity online in coming years that might eventually exceed demand.

Micron, despite its low P/E ratio, is being held back by the prospect of difficult comparisons and the possibility that its extraordinary rally has already priced in earnings growth that has yet to be delivered.

In short, Micron is a microcosm of the earnings issue currently hanging over the market, which has seen multiple compression this year despite the acceleration in earnings growth estimates.

Briefing.com Analyst Insight

The stock market's problem isn't a lack of earnings growth. It is a growing reluctance to pay for that growth without greater assurance that it can be sustained.

That reluctance has produced a meaningful contraction in valuation multiples even as earnings expectations have climbed. It can be viewed as a healthy reset, giving earnings a chance to catch up with prices, or as a warning that investors are beginning to question whether those earnings expectations are achievable.

Lower oil prices, declining Treasury yields that aren't a derivative of safe-haven flight, a less hawkish Fed, and continued evidence of profitable AI investment would certainly help restore confidence. Yet the most important catalyst may simply be companies demonstrating that their earnings growth expectations are warranted.

For now, the S&P 500 is holding near record highs, but it isn't making much headway. That may be a testament to its resilience, but it is also a reflection of its nervousness.

The earnings story still has the makings of a Cinderella ending. Investors, however, seem increasingly concerned about what happens when the clock strikes midnight.

--Patrick J. O'Hare, Briefing.com