Stocks Are Expensive. Earnings Growth Means That May Not Matter.

Traders working at the New York Stock Exchange on Monday. (NYSE)

There is a reason earnings are synonymous with the bottom line—they’re crucial. They can justify high prices and even higher hopes, and can be the difference between being in a bubble and not. Luckily, for now they seem set to keep delivering.

Earnings power is particularly relevant today, when the stock market keeps logging new highs like clockwork on expectations for greater profits. All three major indexes reached record closes on Friday, with the S&P 500 up well over 13% since the start of the year.

“We get it. Equities, particularly the S&P 500, look expensive relative to history,” writes Citi equity analyst Scott Chronert. “Yet, selling expensive equities over the past years has been a mistake.”

With the S&P 500 trading close to 24 times forward earnings, its valuation is rubbing shoulders with those of the tech bubble and the post-Covid global reopening. Growth estimates were high in both cases, and ultimately companies couldn’t meet them.

“The key to market health from here is whether long-run EPS can deliver on embedded expectations,” Chronert says. “This did not happen in the late 1990s and early 2000s.”

That leaves him uneasy about the coming third-quarter earnings season. It will likely contain plenty of better-than-expected reports, but investors are already primed for rosy forecasts and management commentary as well: “Said differently, conservatism in tone from management teams might not be taken well by traders short-term.”

One way for investors to try to decide if they are overpaying for growth is to look at what has contributed to the S&P 500’s valuation historically, and how that might play out going forward.

Chronert broke out three components of the index’s valuation: First, the present value of flat earnings growth, i.e. the trailing 12-months earnings per share growth in perpetuity; second, the additional value of cyclical growth, which incorporates the macro backdrop and gross domestic product trends; and third the additional value of excess or structural growth. Excess growth would be growth generated by the company’s actions or products, not by the broader economy.

His analysis shows that the third factor is playing the biggest role, at levels last seen during the tech bubble and post-Covid rally. Moreover, that breaks down when you look at small- and mid-cap companies: Investors are paying up for artificial intelligence’s future potential when it comes to the biggest players, but valuing smaller ones in line with historical averages.

The upshot is that while he doesn’t expect an earnings collapse as seen during the tech bubble, it does put a burden on big tech to keep proving that AI profits aren’t only big, but durable.

That’s especially true given that the past five years have been an outlier. Chronert found that the structural growth component has accounted for nearly half of the index’s return over the last half decade, ahead of even its peak during the tech bubble and pandemic era. And again, this was much more the case with large-caps than further down the spectrum.

This might seem worrisome, but a bifurcation of catalysts isn’t a bad thing. While AI will remain critical to core large-cap and growth stocks, small and mid-cap companies could get a boost from increasing investor confidence about the economic outlook.

In addition, history shows that high stock prices are sustainable, even over long periods, as long as expected earnings growth materializes.

All of this leads Chronert to conclude that the S&P 500 can be broken into two—AI plays and everything else. “Within the latter, the value of cyclical growth jumps out to us as it reflects fairly benign expectations for underlying economic trajectories from here,” he writes. “As we move further down the Fed rate cut path, should soft landing conditions persist, the benefit is set up to accrue incrementally to the Value, Mid, and Small Cap parts of the market.” And as long as artificial intelligence keeps fueling profits, those rally drivers should stay on track too.

Many other analysts believe we aren’t in another tech bubble, and so far earnings have been holding up—to the point of bucking September’s typical seasonal selloff, and potentially supporting even more multiple expansion. Not to mention that valuation isn’t a very good stock-picking metric.

If you get what you pay for, today’s premium still seems justified.

Write to Teresa Rivas at teresa.rivas@barrons.com