If the stock market's double bubble bursts, it could usher in the next crash

By Joseph Adinolfi

Wall Street analysts warn that both stock prices and earnings expectations are looking frothy

It isn't just stock prices that are looking frothy, Wall Street strategists said.

If you ask a bull to list three reasons why stocks aren't in a bubble right now, they're bound to bring up the forward price-to-earnings ratio.

Enthusiasm around artificial intelligence has propelled stocks higher at a rapid clip. But even as prices of major indexes like the S&P 500 have pushed further into record territory this year, one popular metric used by fundamental analysts suggests stock prices are becoming more attractive, not less.

That's because analysts like to compare the price of a stock with the amount of earnings per share the company is expected to earn over the next 12 months. While stock prices have soared lately, Wall Street earnings estimates have been rising even more quickly.

One year ago, the forward price-to-earnings ratio of the S&P 500 SPX stood at 22.4, according to Dow Jones Market Data. As of Thursday's close, the latest data available, the ratio had slipped to 20.51. That's even as the index has risen by 20%.

As second-quarter earnings season looms, S&P 500 companies are expected to report double-digit profit growth for the seventh straight quarter. Analysts currently have penciled in bottom-up earnings growth of more than 23%, according to FactSet analysts.

But how long companies can keep this up remains to be seen. While valuations still look extreme relative to history, the recent pace of corporate earnings growth also has meaningfully diverged from the long-term trend, Panmure Liberum analysts Joachim Klement and Francisca Reis pointed out in a report shared with MarketWatch.

Using another popular valuation metric, the Shiller CAPE ratio, the S&P 500 is currently valued at around 41 times earnings, the analysts said. That is approaching the record-high CAPE ratio seen during the dot-com era a quarter-century ago.

What is happening with earnings recently is very different from what investors witnessed during the dot-com days. While earnings growth back then was more modest, the S&P 500 recently has been seeing earnings per share grow at a pace that is 1.8 standard deviations above the long-term trend, according to the Panmure analysts.

If one were to adjust recent earnings to account for a more normal pace of growth, the Shiller CAPE ratio would swell to 67.6, or 4.6 standard deviations above the long-term trend. This would surpass the peak of every other asset bubble in U.S. history, the analysts wrote.

Put another way, rather than simply being a bubble in prices, the current setup is approaching a "price bubble on top of an earnings bubble," they wrote.

In a column published in the Financial Times, Klement warned that "supernormal" profits probably won't persist forever, and that at some point, investors will likely need to reckon with financial reality. To be sure, it is possible that earnings could continue galloping higher for the next few years. These kinds of runs often continue longer than investors might expect, he said.

Still, as the major tech companies known as hyperscalers - a group that includes Microsoft (MSFT), Alphabet (GOOG) (GOOGL), Amazon (AMZN), Meta Platforms (META) and Oracle (ORCL) - continue plowing money into building new AI data centers, it is becoming increasingly likely that earnings growth will normalize, as these companies shift from being asset-light to asset-intensive businesses.

Klement and Reis aren't the only analysts to flag that earnings expectations, especially for high-flying semiconductor companies, may have become unrealistically rosy.

Peter Berezin, chief strategist at BCA Research, pointed to earnings bubbles forming in the past. It also happened with banks and home builders during the run-up to the 2007-'08 global financial crisis. In each case, a low price-to-earnings ratio disguised an unsustainable uptick in profits.

"More generally, earnings bubbles are common in industries that are subject to boom-bust cycles. These industries include natural resources, airlines, shippers and importantly for today's environment, semiconductors," Berezin wrote in a report from late May. Wall Street analysts are terrible at anticipating an earnings bubble's peak, Berezin wrote in a third-quarter outlook shared with MarketWatch last week. But once it arrives, stocks could fall between 30% and 50%.

Looking ahead, Andy Costan, CEO at Damped Spring Advisors, said during a May appearance on "Monetary Matters" that the U.S. economy wasn't growing quickly enough to justify the earnings that Wall Street analysts have penciled in. Wall Street veteran Jim Paulsen also said in a recent post that he sees risk in exuberant earnings expectations.

U.S. stocks hit some turbulence in June, and that seemed to carry over into early July, as a powerful momentum trade centered on semiconductor stocks hit a speed bump.

Semiconductor names were powering higher once again on Monday, helping lift the Nasdaq Composite COMP to a gain of 1.1%. The S&P 500 closed less than 1% below its record high, and the Dow Jones Industrial Average DJIA notched a record finish above 53,000, according to FactSet data.

Chelsea Ng contributed

-Joseph Adinolfi

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