Last week marked the unofficial start of earnings season with major banks such as JP Morgan, Bank of America, and Wells Fargo reporting. In aggregate, S&P 500 corporations are poised for their largest year-over-year increase in quarterly earnings in a decade. While that’s certainly good news, the Index is already up a remarkable 53.7% since the end of the first quarter in 2020; its best four-quarter gain since World War II. So what are we watching out for that may indicate the market has gotten ahead of itself?

The run-up in the Index’s price-to-earnings (P/E) over the past year has been driven by a rising numerator, while the denominator fell dramatically. A return to near-zero, short-term interest rates following the onset of the pandemic provides some measure of justification (using a lower interest rate to discount future cash flows results in a higher present value). But normalizing the P/E shows that it’s now at its highest level in the last 20 years; surpassing both the Financial Crisis and Tech Bubble. Consequently, we expect aggregate earnings will need to come in notably higher than the roughly 25% year-over-year growth FactSet is currently estimating in order for further price gains.

While it may seem unlikely that index-level earnings will top the already-high bar, it’s worth noting that quarterly earnings have exceeded consensus estimates by an average of 6.9% over the past three years. And over the past three quarters, earnings have handily beaten expectations by an average of 19.0%. So while we expect a reversion to the mean in the P/E, as long as companies reported earnings continue to top estimates — which we view as likely — we expect the index to continue moving higher; though investors may want to temper expectations.

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