Too much profit is the opposite of “poison”? US stocks are surprised by a growth paradox, and Wall Street warns that peak valuations may reverse the market at any time

The Zhitong Finance App noticed that the latest worrying reason for the US stock market right now is quite outrageous: profit growth is too strong.

As the latest earnings season comes to an end, all signs point to the second quarter being one of the best three months in recent memory, with profit growth of more than 30%.

The only suspense? I'm afraid it will be difficult to sustain this intense momentum. Bank of America strategists said that it is currently generally expected that the growth rate will fall below 20% in the first quarter of 2027 and then slow to a moderate level of around 15% throughout the year. Although this growth rate is still healthy from a historical perspective alone, when profit growth falls from a high level, it is often difficult for the market to maintain the same level of support.

This pattern is likely to push next year's stock market into the weakest phase of US stocks: when earnings per share (EPS) growth is above trend level but is slowing down, the 12-month median annual return of 6.7% for the S&P 500 index is 6.7%, and the probability of an increase is 72.3%, according to Bank of America data. In contrast, when EPS growth was above trend and continued to accelerate, the median return was 14%, and the probability of an increase was as high as 83.3%.

Excellent profit growth

However, in response to this year's huge profit explosion, the historical data set is actually very limited. A team of Bank of America strategists led by Savita Subramanian expect growth to remain above 20% in the third and fourth quarters, which will mark four consecutive quarters of breaking through this level.

Such a winning streak is rare; it has only been seen 10 times since 1936. The strategist notes that several recent cases occurred after EPS experienced a recession, such as during the COVID-19 pandemic and the global financial crisis.

However, the growth rate was not the only bright data in the second-quarter earnings season. According to Citadel Securities, the profits of S&P 500 constituent stocks are also moving towards one of the historical records of how much they have surpassed analysts' expectations the most.

Scott Rubner, head of equity and stock derivatives strategy at the company, pointed out that the company has also driven the strongest upward trajectory of earnings in at least 26 years.

In a report released on Tuesday, Rubner wrote, “The important thing is that this isn't just a story about AI.” “The macroeconomic discussions are still complicated, but the message from the US business community is much simpler: profits have exceeded expectations, and by a huge margin.”

Overall, 85.6% of companies surpassed Wall Street's EPS expectations as of Friday's close, the highest percentage since 2021, the data showed. Furthermore, only 10.6% of companies failed to meet expectations, the lowest figure in three decades.

The suspense now is: is this already the pinnacle?

Ben Inkel, GMO's co-head of asset allocation, said second-quarter earnings were “outstanding.” However, there is a divide between the field of artificial intelligence and the rest of the market. Most of the latter's excellent profits can be attributed to a “cyclical recovery.”

“If the upward trend continues, it is likely to push up inflation and interest rates; if the momentum stagnates, corporate performance may be disappointing compared to the raised forecast,” Inker said.

Although Bespoke Investment Group's analysis shows that companies are raising their growth expectations at the fastest rate in the past 25 years, the agency is being cautious and wary of extreme situations.

Noah Weisberg, chief US stock strategist at BCA Research, believes that the rise in analysts' expectations and the company's own performance guidelines have increased the possibility of “partial overheating,” but he added that profit growth expectations reaching a low range of 10% to 15% in 2027 seem achievable.

However, with interest rates remaining high and large stock supplies pouring into the market as more AI companies go public, it is a dangerous time for earnings growth to peak.

“Given that valuations are high and the IPO wave still needs to be digested by the market at current valuation levels, the bond market is still our main source of concern for the stock market,” Weisberg said. “At some point, investors will naturally choose not to pay peak valuation multiples for peak period profits.”

Investors may be realising that the next few quarters may be setting the bar too high for businesses. Bank of America strategist Jill Carey Hall pointed out that compared with previous quarters, the market's response to performance exceeding expectations and growth was lackluster, which indicates “most of the positive news has already been digested.”

Western Digital, Datadog Inc., SanDisk, and DaVita Inc. all surpassed expectations in terms of revenue and profit, but their stock prices were sold off. According to the data, among companies whose revenue, profit, or both exceeded expectations, the average single-day excess return rate of their stock prices remained flat; while performance that did not meet the standards triggered a more intense sell-off.

Carey Hall said, “Investors are actually already opening positions ahead of time for this positive news and strong profits,” and “as a result, once the stock's performance exceeds expectations, the rewards actually aren't as generous as usually seen.”