The market is searching for a zone where there can be too much of a good thing, with prevailing positive mood leading to higher stock prices. This isn’t about the pace of the index’s rise; the S&P 500 is up nearly 20% since its March 30 low and nine consecutive winning weeks. Rather, it’s a matter of the truly supportive fundamental, technical, and macro factors, such as revenue growth, semiconductor leadership, and generous credit conditions, that could quickly overshoot and drag down returns from here. Corporate Profits Bullish strategists are right to point out that the S&P 500’s rise is underpinned by a tremendous acceleration in reported earnings. S&P 500 index returns are expected to increase by more than 22% this year, up from 17% as of March 31st, due largely (but not entirely) to historic levels of spending on AI infrastructure and massive adoption of cloud services. It’s really rare for earnings to accelerate at this pace, except when companies are emerging from recessions or other macro shocks. To be sure, some of the unexpected turnaround is due to non-operating gains on the giant privately held AI pioneer’s stake, but not all of it. The surge in earnings has pushed the index up 10% from its previous peak on Oct. 29, while compressing the forward price-earnings ratio to 21.4 times from 23 times six months ago. “Stocks follow earnings” is one of the most sane and reassuring maxims in the investor phrasebook. But beyond a certain point, even this rate of earnings growth can start to lose its ability to drive stock prices higher. This is just as a high protein diet can be beneficial, but extreme ‘maximum protein intake’ can be harmful. “When annual earnings growth exceeds 20%, S&P 500 returns are depressed because investors expect companies to not be able to sustain such rapid growth,” said Ed Clissold, U.S. equity strategist at Ned Davis Research. Specifically, over the past 100 years when earnings growth was above 20%, the index returned about 2% annually. The decline in the S&P 500 P/E makes sense from another perspective. When it exceeded 23, it was rightly said that it was pricing in the coming profit millionaire, and indeed we were able to make a profit. And while their generous multiples were often justified based on generous free cash flow generation beneath reported profits, capital spending on AI has stagnated FCF growth. The growing importance of high-tech hardware windfall profits in the supply-constrained food chain could also constrain P/E ratios from here. “Another way to interpret the lower P/E ratio is that if most of the earnings growth comes from cyclical industries like semiconductors and energy, a lower multiple makes sense,” Clissold said. More broadly, runaway reported profits are pushing the share of GDP that goes into corporate profits even higher, already at record levels for decades. To project superior profit growth over the next few years, we need to bet that significant structural changes in the economy will permanently benefit businesses over wage earners, beyond the current unprecedented extremes. Semiconductor Leadership One of the best indicators of the bull market’s tenacity is whether semiconductor stocks are leading the way. This group uniquely reflects cyclical forces, technological innovation, and investor risk appetite. There is a difference between a semi that consistently keeps pace with market progress and a sector that goes to the extremes of the vertical, which happens infrequently. The Philadelphia Semiconductor Index rose 69% in April and May. The only other time it rose more than 60% in two months was during the last surge of the internet bubble bull market in the early 2000s. .SOX YTD Mountain Philadelphia Semiconductor Index, Year-to-Date Trading Pointing to his company’s measure of future expectations based on recent excess returns, Renaissance Macro Strategist Jeff DeGraaf said, “For the first time this cycle, our semi market SERM measurements are in the 95th percentile, and that’s confirmed.” The outsized returns from this parabola are a danger zone and not a sell signal, but when looking out 12 months, understand that past returns are highly unlikely to be sustainable. ” The market-wide impact of a broad and deep correction in heavily overbought semi-stocks is centered around its significant role in high beta/high momentum cohorts. Stock price reversals in this channel often cause volatile fluctuations. I must say that things have been pretty orderly so far. On the other end of the relative performance axis, software stocks rose further on Monday, with mixed action in the semifinals, with winners Nvidia and Micron offset by declines in Intel, Qualcomm and others. Again, it’s a warning, not a sell signal. Stock Correlation When it comes to offsetting behavior, it’s usually a healthy sign when individual stocks chart their own paths in response to specific inputs individually, rather than moving all at once to macro stimuli. That is, up to a certain point. This is a chart of the Cboe 3-Month Implied Correlation Index, a measure of market-based expectations about how correlated stocks have behaved and will continue to behave. Depending on how you look at it, extreme lows reflect both a “stock-picking market” and a market dominated by mechanical rotational flows. This mode suppresses volatility and encourages higher risk-seeking activity until a break. The previous low was in late July 2024, when an unusually narrow bull market culminated in a relative peak for mega-cap tech stocks, which quickly fell 6% and fluctuated in a range for several months. Credit Calm The cyclical part of the stock market is not immune to frictions from rising oil prices, rising Treasury yields, and dashed expectations for Federal Reserve rate cuts. The median value of consumer goods stocks is down 8% from its high, while the typical financial stock is down 6%. Still, there is little evidence of comprehensive macro stress in capital markets. Investment-grade corporate credit spreads are now back to cycle lows, meaning the cushion against adverse surprises is much thinner. As with all of these potential extremes in positive trends, there is nothing to indicate that this deep-seated investor optimism is imminently dashed. Bullish traders will continue to be inspired by the return of the AI hype cycle for upcoming mega IPOs. The continued closure of the Strait of Hormuz, as well as concerns about the impact of these mega IPOs, still pose a barrier to market expansion. But at some point in the market, “things are good” turns into “things can’t get any better.”
