Earnings growth for companies in the S&P 500 Index has been off the charts this year...
According to Charlie Bilello's Week in Charts, as of August 18, second-quarter earnings growth of 29% was "the biggest upside surprise in history."
And it has risen to more than 50% year over year – the highest quarterly growth rate in five years.
As a result, Bilello notes, "S&P 500 earnings are now expected to surge 32% in 2026, more than double the 15% growth expected at the start of the year."
In this chart, you can see how growth has been climbing steadily for the past three years:
This growth is largely driven by the AI infrastructure boom (or "bubble," as I argued in Monday's e-mail).
Earnings of tech companies in the S&P 500 soared 71% year over year in the second quarter. That's all the more remarkable considering just one year ago, these companies saw less than one-third of that growth, as this chart by Ritholtz Wealth Management's Matt Cerminaro shows:
Given that the S&P 500 is "only" up 12% this year – far less than earnings growth – simple math dictates that the index's price-to-earnings multiple has gone down this year.
That means stocks are cheaper and therefore a better buy today than they were at the beginning of the year, right?
Not so fast...
Five of the six periods of extremely high earnings growth in the past quarter century – all but last year – have preceded significant market drops, as this BCA Research chart shows:
My friend Doug Kass of Seabreeze Partners Management agrees that strong earnings per share ("EPS") doesn't equate to strong price gains. In a recent missive (subscription required), he notes:
First-level thinking is lazy, simplistic and superficial – it looks for simple formulas and easy answers. To paraphrase Howard Marks:
- First-level thinking says, "S&P EPS growth will be strong, let's buy the market."
- Second-level thinking says, "S&P EPS growth will be strong, but everyone knows it. Stocks are fairly or overpriced, let's sell the market."
Most recent examples of when S&P EPS was better than expected and strong were in 2018 (+20.5% EPS growth, -6.6% decline in the S&P), 2006 (+16.7% EPS growth, +11.3% rise in the S&P), 2005 (+19.3% EPS growth, +8.8% rise in the S&P) and 2004 (+20.1% EPS growth, +4.2% rise in the S&P).
Going back, during the last 50 years, other 12-month periods with robust EPS growth and less-than-stellar to down S&P price include the years 1993, 1992, 1987, 1984, 1979, and others.
He argues that this year offers a combination of unique market challenges compared with prior periods:
- High and rising inflation and interest rates.
- A burgeoning deficit and U.S. debt load may be a permanent condition giving the general lack of discipline from both parties in Washington DC.
- Improvisational geopolitical and fiscal policies that present threats to political and economic stability.
- Both parties are moving to extremes – the Republican party more to the right and the Democratic party to the left. With a possible Democratic congressional majority win in November, anti-corporate policy (higher corporate taxes, etc.) may be in the offing.
- Traditional valuation metrics in the 98th percentile, two standard deviations above the average.
- The AI capital spending spree and gains from investments have inflated S&P profit reports... an earnings reckoning may lie in the not too distant future.
I think Doug is right that huge corporate earnings growth likely won't translate into a comparable huge rise in stocks.
Unlike Doug, I'm not bearish on stocks in general – with the exception of the AI bubble. When it bursts, stocks that have soared during this boom – such as CoreWeave (CRWV), which I analyzed on Monday – will undoubtedly crash.
But there are plenty of stocks that aren't likely to decline at all – take Berkshire Hathaway (BRK-B), for example.
I most recently analyzed the company's earnings and valuation in my August 10 and August 11 e-mails. As of yesterday's close, it trades at a 12% discount to my calculation of its intrinsic value.
In fact, Berkshire could even benefit from a classic "rotation to safety" if stocks in the AI sector take a bath.
The stocks in my "Discarded Dozen" might be currently benefiting from the same phenomenon...
Since I named them on June 12 and June 15, they're already crushing both the S&P 500 – as measured by the State Street SPDR S&P 500 Fund (SPY) – and SpaceX (SPCX):
It's exactly as I predicted. And I believe this outperformance will continue.
In summary, you might want to think about banking some profits in AI-related stocks. But if you own well-diversified index funds like the S&P 500 and/or modestly valued stocks of quality companies, then don't panic and stay the course.
Best regards,
Whitney
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