Profits Too Strong Become "Poison"? U.S. Stocks Face Growth Paradox as Wall Street Warns Peak Valuations May Backfire on the Market at Any Time

Odaily noticed that the latest worry for the US stock market is rather bizarre: earnings growth is too strong.

As the latest earnings season approaches its end, all signs indicate that Q2 has been one of the most outstanding three months in recent memory, with profit growth rates exceeding 30%.

The only suspense? This red-hot momentum may be hard to sustain. According to Bank of America strategists, it is now widely expected that growth rates will fall below 20% by Q1 2027, and then slow to a medium level of around 15% for the year. Although this pace remains healthy from a historical perspective, markets often struggle to maintain support when earnings growth recedes from high levels.

This scenario could push next year's stock market into its most vulnerable phase: according to BofA data, when earnings per share (EPS) growth is above trend but decelerating, the median 12-month annual return for the S&P 500 is 6.7%, with a 72.3% probability of increase. In contrast, when EPS growth is above trend and continues to accelerate, the median return is 14%, with an 83.3% probability of gain.

Exceptional Earnings Growth

However, when it comes to this year's profit explosion, there is actually very limited historical data. The Bank of America strategist team led by Savita Subramanian expects Q3 and Q4 growth to remain above 20%, which would mark four consecutive quarters above this level.

Such a winning streak is extremely rare, having occurred only 10 times since 1936. Strategists noted that the most recent cases all happened after EPS suffered a recession, such as during the COVID-19 pandemic and the global financial crisis.

And the growth rate is not the only standout figure in Q2’s earnings season. According to Citadel Securities, profits of S&P 500 constituents are also on track for one of the biggest beats versus analyst expectations on record.

Scott Rubner, Head of Equities and Equity Derivatives Strategy at Citadel Securities, pointed out that companies have also driven the strongest upgrade trajectory in earnings in at least 26 years.

“Importantly, this is not just an AI story,” Rubner wrote in a report released Tuesday. “Macro discussions remain complex, but the message from US corporations is much simpler: earnings have outperformed expectations, and by a wide margin.”

As of Friday’s close, 85.6% of companies had beaten Wall Street’s EPS expectations overall, the highest proportion since 2021. In addition, only 10.6% of companies failed to meet expectations, the lowest number in thirty years.

The suspense now: is this already the peak?

Ben Inker, Co-Head of Asset Allocation at GMO, said Q2’s earnings “stood out.” However, there is a divergence between the AI sector and the rest of the market. Most of the latter’s solid earnings can be attributed to a “cyclical rebound.”

“If the rebound continues, it’s highly likely to push up inflation and rates; but if it stalls, corporate performance may be disappointing relative to revised-up forecasts,” Inker said.

Although analysis by Bespoke Investment Group shows that companies are raising their growth forecasts at the fastest pace in 25 years, the firm maintains a cautious stance and is alert to extreme outcomes.

Noah Weisberger, Chief US Equity Strategist at BCA Research, believes that the boost in analyst forecasts and companies’ own guidance increases the possibility of “localized overheating,” but he added that profit growth expectations in the 10%-15% lower range by 2027 appear achievable.

However, in an environment where rates remain high and a wave of new stocks will hit the market as more AI firms go public, an earnings growth peak is a dangerous moment.

“Given valuations are elevated, and the IPO wave still needs to be digested by the market at current valuation levels, the bond market remains our main source of concern for stocks,” Weisberger said. “At some point, investors will understandably choose to stop paying peak valuations for peak earnings.”

Investors may be realizing that the bar for companies in the next few quarters may be set too high. BofA strategist Jill Carey Hall pointed out that, compared to previous quarters, the market’s reaction to earnings beats and growth has been tepid, indicating that “much of the good news has already been priced in.”

Western Digital, Datadog Inc., SanDisk, and DaVita Inc. all posted revenue and profit beats but saw their stocks sold off. Data show that among companies that beat on revenue, earnings, or both, the average single-day excess return in share price was flat; however, earnings misses triggered more severe selloffs.

Carey Hall said, “Investors have actually built positions in advance for these positive surprises and strong earnings,” “Therefore, once stocks outperform expectations, the actual reward is not as generous as what is usually seen.”