The current US stock market not only has a price bubble but also hides an earnings bubble.

Written by: Zhao Ying, Wall Street Journal

The US stock market has reached new highs driven by the artificial intelligence boom, but Wall Street analysts are issuing rare warnings— the risks currently facing the market go far beyond inflated stock prices.

Panmure Liberum analysts Joachim Klement and Francisca Reis pointed out in their latest report that the US stock market is brewing both a "price bubble" and an "earnings bubble," creating a "double bubble" structure.

If using the cyclically adjusted Shiller price-to-earnings ratio (Shiller CAPE) as a benchmark and adjusting corporate earnings to a long-term normal growth rate, the current valuation of the S&P 500 would reach as high as 67.6 times, surpassing all peak values of asset bubbles in US history. BCA Research Chief Strategist Peter Berezin warned that once the bubble bursts, the US stock market could fall by 30% to 50%.

Despite this, the US stock market has maintained strength recently. As of the close on Monday, the S&P 500 was less than 1% away from its historical high, the Dow Jones Industrial Average broke 53,000 points to set a new record, and the Nasdaq Composite Index rose by more than 1%, with the semiconductor sector once again leading the charge.

Forward P/E "distortion": Earnings growth expectations far exceed historical trends

In the bullish camp, the forward price-to-earnings ratio (Forward P/E) is often cited as a justification for why stock market valuations are still reasonable. According to Dow Jones Market Data, the forward P/E of the S&P 500 has decreased from 22.4 times a year ago to 20.51 times, even though the index has risen by about 20% during this period. Behind this phenomenon is the fact that Wall Street's earnings growth expectations have outpaced the increase in stock prices themselves.

According to FactSet data, analysts currently expect the second-quarter earnings growth rate for S&P 500 constituents to exceed 23%, marking the seventh consecutive quarter of double-digit earnings growth.

However, Klement and Reis pointed out that this earnings growth rate shows a significant divergence from the long-term trend. Currently, the growth rate of S&P 500 earnings per share is higher than the long-term trend by 1.8 standard deviations, representing an "abnormal" level. They believe that if the earnings growth rate is adjusted back to the normal trajectory, the Shiller CAPE ratio would surge from the current level of about 41 times to 67.6 times, deviating from the long-term trend by 4.6 standard deviations, surpassing the peak values of every previous asset bubble in US history.

Giant tech companies transforming, pressures for normalizing earnings growth gradually emerging

Analysts point to the core risk of the current earnings bubble as the "super-scale cloud computing companies" represented by Microsoft, Alphabet, Amazon, Meta Platforms, and Oracle.

Klement warned in a column for the Financial Times that "abnormal" profits cannot be sustained indefinitely. As these tech giants continue to invest massively in AI data center construction, their business models are shifting from light assets to heavy assets, and this structural change will suppress earnings growth, causing it to gradually return to normal levels.

Klement also acknowledged that such high-growth earnings cycles often last longer than investors expect, and the current earnings growth momentum may still continue for several years.

Historical precedent: low P/E ratios once concealed earnings bubbles

BCA Research's Peter Berezin referenced historical cases to further elucidate the dangers of earnings bubbles. He pointed out that prior to the 2007-2008 global financial crisis, banks and home builders also experienced an irrational boom in earnings, during which low P/E ratios masked the unsustainability of profits.

"More generally, earnings bubbles are quite common in industries characterized by boom-bust cycles, including natural resources, aviation, shipping, and particularly in the current environment, the semiconductor industry," Berezin wrote in a report at the end of May. In the third-quarter outlook he released last week, he further pointed out that Wall Street analysts have performed poorly in judging the peak of earnings bubbles, and once the bubble bursts, the stock market could fall by 30% to 50%.

Concerns about overly optimistic earnings expectations are not isolated. Andy Costan, CEO of Damped Spring Advisors, stated in the May "Monetary Matters" program that the growth rate of the US economy is not sufficient to support the earnings levels set by Wall Street analysts. Veteran Wall Street figure Jim Paulsen has also recently expressed in a public post that he believes the current market's overly optimistic sentiment toward earnings poses a risk.

Meanwhile, the US stock market experienced volatility in June, continuing into early July, with strong momentum trading in semiconductor stocks encountering resistance at one point. However, the semiconductor sector regained upward momentum on Monday, driving the Nasdaq Composite Index up 1.1%, and market sentiment temporarily stabilized.