The latest reason to worry about the stock market is quite the doozy: Earnings growth has been too strong. As the latest reporting season nears completion, all signs indicate the second quarter was one of the best three-month periods in recent memory, with profit growth running at more than 30%.The only problem? That torrid pace is unlikely to last. The consensus currently expects growth to fall below 20% in the first quarter of 2027 before moderating into the mid-teens for the full year, according to strategists at Bank of America Corp. While in isolation those rates are healthy from a historical standpoint, the market often has been less supportive when earnings growth decelerates from elevated levels.It’s a recipe that could potentially place next year’s stock market in the weakest phase for equities: When earnings-per-share growth is above trend but decelerating, the S&P 500’s median 12-month return is 6.7% with a hit rate of 72.3%, according to BofA. That compares with a median 14% return and a hit rate of 83.3% when EPS growth is above trend and accelerating. Still, the historical data set is very limited when it comes to the type of profit bonanza unfolding this year. BofA strategists led by Savita Subramanian expect growth to remain above 20% in the third and fourth quarters, which would mark four consecutive quarters above that level. Streaks like that have been rare, occurring only 10 times since 1936. The most recent examples have taken place after EPS recessions, the strategists said. Examples include COVID and the global financial crisis.And the growth rate is not the only standout statistic for the second-quarter reporting season. S&P 500 Index profits are also heading toward one of their largest beats on record versus analysts’ estimates, according to Citadel Securities. Scott Rubner, head of equity and equity derivatives strategy at the firm, noted that companies are also driving the steepest earnings-estimate revision path in at least 26 years.“Importantly, this is not just an AI story,” Rubner wrote in a note published on Tuesday. “The macro debate remains complicated, but the message from corporate America is much simpler: earnings are better than expected, and by a wide margin.”Overall, 85.6% of companies exceeded Wall Street’s EPS expectations through Friday’s close, which is the highest percentage since 2021, data compiled by Bloomberg Intelligence showed. Furthermore, only 10.6% of companies have failed to meet expectations, which is the lowest number in three decades.The question now: Is this is as good as it gets?Ben Inker, co-head of asset allocation at GMO, said that earnings have been “extraordinary” in the second quarter. However, there was a difference between the artificial-intelligence space and the rest of the market. Much of the latter can have its good earnings attributed to a “cyclical upturn.”“If the upturn continues, it is very likely to push up inflation and interest rates, and if it falters, companies are likely to disappoint relative to upgraded forecasts,” said Inker.While Bespoke Investment Group’s analysis shows companies are boosting their growth expectations at one of the highest clips in the last 25 years, the firm is exercising caution and warning of extremes.The elevation in analysts’ expectations and companies’ own guidance boosts the likelihood that “pockets of excess will emerge,” according to Noah Weisberger, chief US equity strategist at BCA Research, though he added that low-teens earnings growth expectations for 2027 looks achievable.Yet with interest rates elevated and a large amount of equity supply set to hit the market when more AI companies go public, it’s risky time for earnings growth to peak. “The bond market remains our chief source of concern for equities, given stretched multiples and an IPO wave that still needs to be absorbed at current valuations,” said Weisberger. “At some point, investors will rightly choose not to pay peak multiples for peak earnings.”Potentially, investors are realizing the bar now may be too high for companies in the coming quarters. BofA strategist Jill Carey Hall noted that market reactions to earnings beats and growth have been somewhat more muted in comparison to prior quarters, suggesting that “a lot of the good news has been priced in.”Western Digital Corp., Datadog Inc., Sandisk Corp. and DaVita Inc. all beat on the top and bottom lines but sold off. Indeed, Bloomberg Intelligence data has shown companies that have beaten on revenue, earnings, or both have on average seen flat one-day excess returns. And misses have triggered steeper selloffs. “Investors already were kind of positioning for this good news and strong earnings,” said Carey Hall. “Then once the stocks beat that, that reward isn’t really transpiring to be as much as you normally would see.”Leon writes for Bloomberg.
