The market is probing the zone where the prevailing positives driving stocks higher could cross the line into too much of a good thing. This is not about the pace of index gains, the S & P 500's near-20% run off the March 30 low or the nine straight winning weeks. It's more a matter of the genuinely supportive fundamental, technical and macro drivers around earnings growth, semiconductor leadership and generous credit conditions that could soon overshoot in a way that drags on returns from here. Corporate profits Bullish strategists are correct in pointing out that the S & P 500's advance has been substantiated by a stupendous acceleration in reported earnings. Largely (but not entirely) due to the historic level of spending on AI infrastructure and massive uptake of cloud services, S & P 500 earnings this year are now projected to rise by more than 22%, up from 17% on March 31. Such a pace of profit acceleration is genuinely rare outside of periods when companies are emerging from recessions or other macro shocks. True, some if the upside surprise has come from non-operating gains on holdings in huge, private AI pioneers, but not all of it. This earnings surge has enabled the index to rise 10% since its former peak on Oct. 29 while compressing its forward price/earnings multiple to 21.4 from above 23 six months ago. "Stocks follow earnings" is one of the most wholesome and reassuring maxims in the investor phrasebook. Yet beyond a certain point, earnings rising at this pace can begin to lose their ability to carry share prices higher, the same way that high-protein diets are beneficial but extreme "protein-maxing" can be harmful. Ned Davis Research U.S. equity strategist Ed Clissold points out that "when year/year earnings growth has exceeded 20%, S & P 500 returns have been weak. The reason is that investors anticipate that companies will not be able to maintain such rapid growth." Specifically, in the past 100 years, when profit growth was running above 20%, annualized index returns were around 2%. The compression in the S & P 500 P/E makes sense from another angle, too. When it was above 23, it was properly said to be pricing in a coming profit bonanza, and sure enough we have one. The rich multiples were also frequently justified on the basis of copious free-cash-flow generation underneath the reported profits, but FCF growth has stalled due to all the AI capital spending. The increasing importance of tech-hardware windfalls along a supply-constrained food chain might also restrain the P/E from here. As Clissold says, "Another way to interpret the falling P/E is if a larger portion of earnings growth is going to come from cyclical industries like semiconductors and energy, then a lower multiple would be warranted." In a broader frame, the runaway reported-earnings growth is further pushing up the share of GDP flowing into corporate profits, already at a record level going back many decades. Projecting multiple years of superior earnings growth from here requires betting that profound structural changes to the economy will durably benefit companies over wage-earners beyond the current unprecedented extremes. Semiconductor leadership One of the best indicators of a bull market's fortitude is whether semiconductor stocks are leading. The group uniquely reflects cyclical forces, technological innovation and investor risk appetites. There's a difference between semis consistently pacing a market advance and the sector going vertical to rare extremes. The Philadelphia Semiconductor Index jumped 69% in April and May. The only other time it jumped more than 60% over two months was in the final surge of the Internet bubble bull market in early 2000. .SOX YTD mountain Philadelphia Semiconductor Index, YTD Pointing to his firm's gauge of forward expectations based on recent excess returns, Renaissance Macro strategist Jeff DeGraaf says, "For the first time in this cycle, our SERM reading in semis is now in the 95th percentile, confirming the outsized returns that have been delivered in this parabola. It's a danger zone, not a sell signal, but understand the historical returns are highly unlikely to be sustainable as we look out 12 months." The market-wide implications of any broad, deep correction in profoundly overbought semi stocks center around their linchpin role in the high-beta/high-momentum cohort. Reversals in this channel of stocks often lead to erratic whipsaws. So far, it should be said, things have been rather orderly. Monday there was a further rally in software stocks – the other end of the relative-performance axis – along with mixed action in semis, with winners Nvidia and Micron offset by weakness in the likes of Intel and Qualcomm. Again, a warning, not a sell signal. Stock correlations Speaking of offsetting action, it's typically a healthy sign when individual stocks are charting their own path, responding separately to specific inputs rather than moving in unison to macro stimuli. Up to a point, that is. Here is a chart of the Cboe 3-Month Implied Correlation Index, a gauge of market-based expectations for how correlated stocks have behaved and will continue to act. Extreme lows reflect both a "stock picker's market" and one dominated by mechanical rotational flows, depending on one's view. This mode suppresses volatility and encourages higher risk-seeking activity, unless and until it breaks. The prior low was in late July 2024, when an unusually narrow rally culminated with a relative peak in mega-cap tech stocks, a quick 6% pullback and range-bound churn for a couple of months. Credit calm Cyclical parts of the equity market have surely not been ignoring the frictional effects of elevated oil prices, higher Treasury yields and dashed hopes of Federal Reserve rate cuts. The median consumer-discretionary stock is 8% off its high, the typical financial off by 6%. Still, there is very little evidence of comprehensive macro stress in the capital markets. Investment-grade corporate-credit spreads are now back to cycle lows, meaning the cushion against adverse surprises has worn pretty thin. As with all these potential extremes in positive trends, nothing says this embedded investor optimism will be dashed imminently. The revving of the AI hype cycle into the coming mega-IPOs will likely keep the bullish traders stimulated. The continued closure of the Strait of Hormuz and even the concerns about the impact of those huge IPOs are maintaining a residual wall of worry for the market to scale. But at some point in markets, "Things are good" turns into "Things can't get any better."
<small>Source: CNBC</small>
