STOCKS ARE ABOUT TO DO THE "UNTHINKABLE"

SUMMARY

Brandon, a seasoned investor, analyzes the current state of the stock market, highlighting both significant risks and robust profit growth among major companies. He discusses inflation pressures, interest rate expectations, and the implications of strong corporate earnings for future market performance.

MAIN POINTS

• Oil prices have surged 69% year-to-date due to blockades in the Strait of Hormuz, contributing to rising inflation expectations. [1:01]
• Interest rates and bond yields are rising, making risk-free government bonds more attractive compared to stocks, which could pressure equity valuations. [3:00]
• Q1 earnings season showed that 84% of S&P 500 companies beat earnings per share expectations and 81% beat revenue expectations, with earnings growth at 28% year-over-year. [6:00]
• Forward earnings projections remain strong, suggesting continued profit growth and supporting current market valuations despite being slightly above historical averages. [10:00]
• Despite the potential for significant market corrections, sustained high profit growth could justify ongoing market rallies, and investors are advised to maintain balanced portfolios. [13:01]
• Long-term optimism persists for the U.S. and global economies, but short-term volatility is expected due to geopolitical risks and technological changes. [14:01]

DETAILED ANALYSIS

The current environment for the stock market is characterized by heightened uncertainty and significant cross-currents. Oil prices have experienced a dramatic 69% year-to-date increase, primarily due to blockades in the Strait of Hormuz, a critical passage for oil exports from Iraq, Saudi Arabia, the UAE, and Iran. This disruption has directly contributed to rising inflation expectations, as higher energy costs filter through to broader consumer prices, impacting the cost of housing, vehicles, and other goods.

In response, bond yields have climbed, with the 10-year U.S. Treasury offering a 4.5% return, making it an increasingly attractive alternative to equities, especially as the stock market's average annual return hovers around 10%. The possibility of further interest rate hikes remains a key concern, as higher rates typically act as a drag on stock valuations by increasing the appeal of risk-free assets and raising the cost of capital.

Valuations in the equity market are approaching levels seen before previous major downturns, such as the dot-com crash and the global financial crisis. The S&P 500's price-to-earnings (PE) ratio currently stands at approximately 21, above its 10-year average of 19 and 5-year average of 20, signaling that stocks are somewhat expensive relative to historical norms. However, this elevated valuation is partially offset by exceptionally strong corporate earnings growth.

In the most recent Q1 reporting season, 94% of S&P 500 companies reported results, with 84% surpassing earnings per share expectations and 81% exceeding revenue forecasts. Year-over-year earnings growth reached an impressive 28%, far outpacing the long-term average of 10% annual profit growth for the S&P 500. This robust performance is attributed to resilient consumer demand, technological advancements, and continued strength in key sectors such as technology.

Forward-looking indicators suggest that this momentum may continue, with projections for sustained earnings growth in the coming year. Data from independent sources like Yardeni and FactSet both confirm that forward earnings expectations remain high, reinforcing the argument that current valuations, while elevated, are justified by underlying profit trends. Historical analysis shows that stock prices tend to follow profit growth over time, and the current disconnect between prices and earnings is relatively modest—around 10%.

As long as earnings per share continue to rise, the risk of a severe overvaluation-driven correction is mitigated.

Nonetheless, several risks persist. Inflationary pressures from oil prices and lingering effects of tariffs could prompt the Federal Reserve to consider further rate hikes, although the current consensus is that rates are unlikely to increase significantly this year. Should inflation moderate, bond yields may decline, enhancing the relative attractiveness of equities and providing a bullish catalyst for further market gains.

However, any slowdown in profit growth, particularly from major contributors like Nvidia or the broader technology sector, could quickly alter this outlook. The potential for sharp corrections—ranging from 20% to even 40%—remains ever-present, especially in a market environment prone to sudden shocks from geopolitical events or unexpected economic developments.

Investors are encouraged to maintain diversified portfolios, focusing on quality companies at reasonable valuations and employing prudent risk management strategies, including responsible use of options. While short-term volatility is expected, the long-term outlook remains positive, driven by strong earnings growth and innovation, particularly in areas such as artificial intelligence. The key to success in this environment is disciplined allocation and a focus on fundamentals, rather than reacting to daily headlines or market noise.

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