The S&P 500 has had an amazing quarter but is it a safe bet?

With Q2 results season now out of the way in the US, average earnings for the constituents of the S&P 500 index (which accounts for over 50% of the entire world's stock market value) were a remarkable 50.4% higher than last year. 

Equally impressive was the breadth of the performance. Ten of the 11 major sectors saw positive earnings growth with eight in double digits. Communications Services, Energy and Consumer Discretionary were big winners, alongside the consistently outperforming technology sector, while some 87% of constituents beat forecast Earnings Per Share estimates.  

This should be good news for anybody with a pension, given the sizeable proportion that is likely invested in the S&P 500, and it’s true to say that the S&P 500 has put in a strong performance to date in reaction to the Q2 earnings. Up 4.5% in the past month alone. 

Despite the positive results and momentum this doesn’t mean US equities are an entirely safe bet. Firstly, the underlying Q2 earnings performance wasn’t quite what the headline numbers would have us believe, with an extra $150 billion of ‘Other Income’ clocked up from big tech’s investments in private AI companies such as Anthropic. Stripping out these effects left a more sedate, though still impressive, 29% average earnings growth.

Also, the Wall Street Journal markets page shows that the S&P 500 trades at 21.4 times its forecast earnings for the coming 12 months. This rating requires continued high growth rates to justify, a feat extremely difficult to consistently achieve, such that there is little room for performance error.  The FTSE 100 for example trades at 13.0 times forward earnings.

In addition, the 30-year US treasury yield has risen to over 5.3% to hit a 19 year high today, providing heightened competition to equity investment. The rise follows fears of stickier inflation from a war in Iran that looks increasingly far from over as well as a jump in the US fiscal deficit to $432bn in July, pushing the year-to-date shortfall to almost $1.8 trillion. The US’s fiscal profligacy, with its mind-boggling $40tn debt, also represents a currency risk to foreign investors. 

Furthermore, a blog post published yesterday by European Central Bank economists warned that a correction in US technology stocks was likely and “should be expected even if current valuations were rational.” 

Their research showed that in all previous investment booms driven by transformative technologies, company valuations rose rapidly, owing to initial excitement, before undergoing significant crashes. 

These crashes occur even when the technology is ultimately successful, as the time taken to build the infrastructure is always longer than early enthusiasts predict. Profit expectations therefore fall short, panic ensues and valuations undergo a painful reset. 

Only after this stage does the technology begin to deliver on its promises with the surviving companies going on to deliver steady growth until early valuations are eventually justified.  This was true of the railway boom in the UK almost 200 years ago and, for those old enough to remember, of the internet boom at the turn of the 21st century. 

If there is an AI fuelled reckoning for investors on the way this won’t be entirely confined to the US, with global spillover more than assured. However, the US market will surely bear the brunt and so it pays to maintain a well-diversified portfolio across multiple geographies even if US companies are, for the time being, flying high.