NYSE
The market’s red-hot earnings-fueled rally may about to run out of steam, a Wall Street veteran says.
Jim Paulsen, the former chief investment strategist at the Leuthold Group, is raising concerns about the recent rally in stocks — much of which has been fueled by rapid earnings momentum among the market’s largest companies.
Of all the S&P 500 firms that have reported their results for the second quarter so far, 86% have beaten on earnings, with the overall index on track to post its highest earnings growth rate since 2021, according to the latest update from FactSet.
But there might be a limit to how much higher earnings can climb, Paulsen said, laying out a handful of red flags he sees that suggest earnings growth may be poised to cool off, eliminating one of the main driving forces of the bull market lately.
“Contemporary stock market bullishness is being driven primarily by incredible profit momentum,” he wrote in a recent post on Substack, raising questions about whether the market could sustain that momentum, particularly “relative to rising expectations.”
Here are the five warning signs Paulsen says he’s eyeing:
1. The earnings boom is narrower than it has been in the past
A smaller portion of companies in the S&P 500 are contributing to the earnings boom than in previous years, Paulsen said.
The number of firms in the benchmark index that have seen 12-month forward earnings-per-share estimates rise over the last four weeks currently stands at 122, down from a peak of 163 in 2020, he said.
“That is, current earnings momentum may prove more vulnerable than perceived since it appears far more limited compared to past earnings booms,” Paulsen added of narrow earnings breadth.
2. Higher rates, tighter policy risk pressuring earnings
Paulsen pointed to the potential for more contractionary monetary and fiscal policy, which could pressure earnings momentum going forward. The 10-year US Treasury yield, one measure of long-term rate expectations and a reflection of how tight monetary policy is, is trading around 4.63%.
“As demonstrated, bond yield movements have tended to have about a 24 month ‘leading’ relationship with earnings. Higher yields don’t immediately impact earnings power but do eventually worsen profit outlooks,” Paulsen added of the potential impact on stocks.
Fiscal policy may also be a headwind for profits, he said, pointing to the declining US deficit-to-GDP ratio.
“On this front, fiscal juice has been declining for the last two years, and similar to the impact of higher bond yields, has been ‘pressuring’ corporate profitability,” Paulsen added.
3. Corporate profit margins may be approaching the ceiling
The measure of total US corporate profits as a percentage of GDP stands at around 14%, the highest level since World War II, Paulsen said.
“Perhaps technological advances will persistently keep raising profit margins, but eventually reaching a technical upper limit seems more likely and US companies may be nearing such a point,” he added.
4. Commodity prices flashing a warning
Large increases in commodity prices have historically been followed by a decline in corporate earnings. The earnings per share of the S&P 500 has dropped following every peak in commodity prices since 1970, Paulsen said.
Oil prices remain elevated as the war in the Middle East drags on. Brent crude, the international benchmark, traded around $87 a barrel on Thursday.
“If oil prices have peaked, historically, this is often a time when earnings begin to struggle,” Paulsen said.
5. Cyclical stocks are underperforming
Cyclical stocks, which tend to underperform before corporate profits start to fall, have been struggling.
The consumer discretionary and real estate sectors, two cyclical corners of the S&P 500, have lagged the broader index recently, posting slight losses over the last three-month period.
“Historically, cyclical stock performance has often been a ‘leading’ indicator of profit trends,” Paulsen said.
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Jennifer Sor is a senior reporter at Business Insider. She covers financial markets and the economy, with a focus on retail investing, job trends, and the pursuit of wealth. She regularly speaks to famed forecasters and top investors in markets, and her work has been featured in outlets such as Forbes, Bloomberg Opinion’s “Money Stuff,” and SiriusXM Business Radio. She also appears regularly on television and radio to speak about markets and the US economy.Prior to her time at Business Insider, Jennifer covered tech and business news at the San Francisco Chronicle and Los Angeles Business Journal. She graduated from the University of California, Santa Barbara with a bachelor’s degree in economics and English.Have an interesting story to share? Please reach out to her at jsor@businessinsider.com or @jennreports.81 on the encrypted messaging app Signal.
