Wall Street Is Cautious About the Market Rally. What Will Really Drive Stocks Now.

Companies might be eating tariff costs, which could ripple into earnings season. Above, the manufacturing facilities of the Independent Can Company in Belcamp, Md. (RYAN COLLERD/AFP via Getty Images)

Wall Street is still treating the current stock market rally with caution, even after a near 30% or trough-to-peak surge for the S&P 500 over the past three months, as tariff and interest-rate uncertainty linger into the start of the second-quarter earnings season.

Stocks are still hovering near all-time highs, powered in part by the continuing outperformance of megacap tech stocks and the prospect of Federal Reserve interest-rate cuts. But a disappointing earnings season could test the market’s current momentum and blunt potential gains into the back half of the year.

Sameer Samana, head of global equities at Wells Fargo Investment Institute, sees the tariff impact on second-quarter earnings, and near-term profit outlooks, as a linchpin for the market heading into the autumn.

“The key will be how much demand deterioration you see if you’re passing tariff price hikes along [to customers], or are you eating the tariffs and eroding your profit margins?”, he remarked to CNBC on Monday.

LSEG data suggest collective earnings for the S&P 500 over the second quarter are likely to rise just 5.8% from last year, a sharp slowdown from the 13.7% pace over the first quarter.

Overall revenue growth, however, is expected to slow only modestly, to 3.7% from 5%, suggesting that profit margins are taking a bigger hit than overall demand is.

Samana, however, thinks investors might not get clarity on the tariff earnings impact until early next year. “Markets aren’t going to wait until 2026—they’re going to run with their best guess,” he added. “Right now, there’s an inkling that exports outside the U.S. are paying them, at least initially, and that’s seen as a positive.”

July is usually the best month of the year for stocks, as well, with data from Yardeni Research going back to 1928 showing an average gain of 1.7% for the S&P 500.

But the market is historically expensive, and that could keep a lid on near-term gains even if the earnings season were to exceed analysts’ forecasts. The S&P 500 is trading at 22.2 times Wall Street’s earnings estimates for the next 12 months, which are pegged at around $280 a share.

The so-called equity risk premium, a measure of the extra return investors demand to hold stocks over risk-free Treasury bonds, was last marked at 237 basis points, or 2.4 percentage points, near the lowest level since 2002.

“Elevated valuation could limit market upside, but it is rarely a sell catalyst on its own,” said Bob Doll, CEO and chief investment officer at Crossmark Global Investors.

Instead, he thinks the market’s next move could be defined by whether investors can “look through the messy economic data in the next few quarters to better growth prospects next year.”

“However, with the equity market trading at over 22 times forward earnings and upward pressure on bond yields constraining the upside for valuations, the near-term risk/reward is unappealing,” he cautioned.

Barry Bannister, managing director and chief equity strategist at Stifel, is even more direct, calling overvaluation the most important risk for markets. He sees a “market echo” from the first quarter, which dragged stocks to their early April lows, repeating itself over the second half of the year.

“The environment we expect of slowing core GDP with sticky inflation favors a market echo of the stagflation trade, which is what outperformed in the first-quarter correction,” he said.

In Bannister’s estimation, that leaves the S&P 500 vulnerable to a 12% pullback from current levels, taking it to the mid-5000 point mark.

“An S&P 500 correction likely pivots on whether a U.S. consumer pullback causes Big Tech to show its more cyclical stripes,” he said. “But earnings estimators may not see the correction coming since price/earnings compression may lead the rotation (into defensive stocks) we expect.”

Write to Martin Baccardax at martin.baccardax@barrons.com