U.S. equities face valuation test as earnings expectations surge

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U.S. equities valuation test

Highlights

Second-quarter S&P 500 earnings are forecast to grow 24% year-over-year, while the 12-month forward P/E ratio has fallen from nearly 22 to 20.7 as the index flattens.
Hyperscalers Microsoft, Alphabet, Amazon and Meta now represent 16% of the S&P 500 and are using all free cash flow for AI computing capacity, restraining the broader market multiple.
S&P 500 trading has turned sideways and technology shares weakened since mid-May, with much of expected second-quarter EPS growth (median 8%) already priced in.

Earnings surge meets market hesitation

As reported by CNBC, the central market debate is whether earnings growth has become so strong that investors are reluctant to assume it can last. Forecasts point to second-quarter earnings growth of 24% from a year earlier, while the S&P 500's 12-month forward price-to-earnings ratio has compressed from near 22 to 20.7 as the index flattens.

A major share of the increase still comes from semiconductor companies and other beneficiaries of AI-related capital spending, though gains are also broadening across more sectors and companies. That leaves investors asking how the market should absorb earnings acceleration more typical of a rebound from recession even as the U.S. economy remains in a long expansion and profit margins already sit near record highs.

Jim Paulsen of Paulsen Perspectives argues that history offers reason for caution when both stock prices and earnings move far above long-term trend lines at the same time. His view suggests investors may fear that Corporate America is over-earning or pulling forward benefits from an investment boom whose costs could emerge more fully over time.

AI spending reshapes profit quality outlook

The AI investment cycle is also changing how investors judge the quality of profits behind the index. Four hyperscalers, Microsoft, Alphabet, Amazon and Meta, now account for 16% of the S&P 500 and are using essentially all of their free cash flow to expand computing capacity, while semiconductor makers, with an index weighting near 18%, benefit from that spending through high prices and supply constraints.

That shift is acting as a restraint on the broader market multiple because hyperscalers no longer command the same valuation premium tied to effortless profitability, and semiconductor companies still trade more like cyclical businesses. After a 15% drop for semiconductor stocks as a group in three weeks, investors appear to need fresh confirmation that aggressive capital expenditure plans for 2027 and beyond will continue.

Bank of America strategist Savita Subramanian says current earnings momentum still looks firm, supported by technology and energy estimate upgrades, solid guidance trends and expansionary ISM PMI readings. Still, the median S&P 500 company is expected to post second-quarter EPS growth of 8%, roughly in line with the median stock's gain this year, suggesting much of the improvement is already recognized by the market.

Subramanian also flags weaker earnings quality, including limited free cash flow and valuation markups on large private AI stakes held by Amazon and Alphabet. Recent sideways trading in the S&P 500 and softer technology performance since mid-May may indicate the market is moving to a more neutral stance ahead of results, especially after Micron Technology sold off sharply despite reporting strong numbers.

Our earlier article on the rotation in U.S. equities described investors broadening beyond megacap tech as AI infrastructure spending lifted smaller, domestically oriented companies, with the Russell 2000 outperforming. We also noted that while hyperscalers’ heavy AI capex is boosting suppliers, much of the small-cap surge has been concentrated in unprofitable tech names, raising concerns about froth despite seemingly attractive valuations in parts of the market.

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