Over the past month, global equity markets have adjusted to an expectation that the U.S. Federal Reserve may be nearing the end of its interest rate cutting cycle. After a subdued early start to the year, markets experienced some renewed strength over the past week. A combination of strong employment figures and lower than expected inflation readings proved to be a catalyst for a return of some enthusiasm. Below, we discuss the drivers of market performance and why the earnings trajectory may become increasingly important over the next few years.

Stock markets tend to be driven by two factors: the expected earnings from the companies within the market and the value that investors are willing to subscribe to those earnings. The former tends to ebb and flow along with the upswings and downswings of the economy. The natural tendency for the economy is to grow, and earnings growth therefore tends to be more positive than negative. Valuations, on the other hand, are more heavily influenced by investor sentiment and can change, sometimes significantly, from one year to the next as investors anticipate whether conditions will improve or deteriorate in the future.

The changes in the valuations for the U.S. S&P 500 index as measured by its forward Price to Earnings (PE) ratio for 2022, 2023 and 2024 were -22%, +17% and +10%, respectively. Today, the forward PE ratio is 21, above its long-term average of 16. On a relative basis the U.S. equity market is expensive, but not at extreme levels of valuation. Excluding the mega cap tech group, the market’s PE ratio is below 20, reflecting that the valuations for the balance of the market, while not as stretched, are above average. History has taught us that valuations can stay elevated for some time, sometimes for years. Valuations could move even higher, as high prices often lead to even higher prices. There is still potential upside for U.S. stocks if investor sentiment with respect to the future becomes more positive.

Given elevated valuations, the foundation for future market gains is increasingly shifting to earnings growth. Earnings growth for the S&P 500 was roughly 3%, 6% and 12%, respectively, for the past three years. Much of the growth was fueled by the large-cap technology stocks whose earnings growth has benefitted from capital expenditures related to artificial intelligence. This trend is expected to reduce somewhat this year. In addition, the recent emergence of Chinese company DeepSeek and its reported lower-cost AI model has called into question the future exclusivity of the tech giants in the AI development space.   

While growth for technology is expected to remain robust, growth in other sectors is expected to broaden and accelerate, leading to mid-teens earnings growth for the broad market over the next few years. Some of the tailwinds that are expected to support earnings among U.S. companies include reduced regulation, lower taxes, and reacceleration of economic growth.

Expectations are high, particularly in the technology sector. Companies will need to deliver on the earnings growth forecasts that are embedded in current market prices. We will pay close attention during the earnings season that is now underway, particularly to the outlooks expressed by company management teams.

If you have any questions, please do not hesitate to contact us.

 

Drew M. Pallett, LL.B.

Senior Portfolio Manager and Investment Advisor       

Email: drew.pallett@rbc.com