Stocks Outlook Hinges on Consensus Getting Earnings Right

Abstract:

• U.S. equity market multiples have been dropping for a year under the pressure of rising interest rates, but earnings forecasts proved easy for stocks to hurdle, helping to propel equities. Multiples are less obviously extended today, but whether stocks are "cheap" or not relies on if the consensus outlook for earnings is correct.
• A wide gap between trailing and forward multiples has emerged, further confirming that the market outlook is heavily dependent on earnings. At the market level, discounts are available, but they are heavily reliant on the consensus forward earnings outlook proving to be correct.
• In the era of heavy concentration, index level views are still distorted by the biggest stocks, especially the Magnificent-7. While this group is now more discounted than it has been in recent years, their high absolute multiples continue to hide many discounts below the surface. The equal weighted S&P 500 is discounted to recent average on both forward and trailing PE.
• More than 64% of large cap stocks and eight of eleven GICS sectors have a majority of constituents trading at a discount to 5-year averages. However, 54.7% are discounted on a trailing P/E basis. Utilities, real estate, materials and financials have the largest gap between percent of companies discounted on forward versus trailing preferred valuation metric.

Equity market valuations are currently in conflict - on a trailing basis, stocks are expensive but on a forward basis stocks are starting to look cheap. Currently, the index trades at 24.7x trailing earnings versus 19.2x forward earnings - 0.9 standard deviations above and 0.4 deviations below recent 5-year averages, respectively. This large spread is unusual at 2.2 standard deviations above the average since 1995 and suggests the market outlook is highly contingent on the earnings outlook at this time. In fact, the only other times where the gap between trailing and forward multiples were this large were in 1999, 2002-2003 and 2021 - each right before or after major market downdrafts. Which view of S&P 500 multiples proves more correct will depend on if consensus' 27.8% earnings growth forecast materializes or not. Recent history shows that the sell side has undershot reality in every quarter but 1Q20 since 2013. While bubble fears still appear overblown, as today's multiples still pale in comparison to 1999-2000's trailing and forward P/E peaks of 31.2x and 25.6x, respectively, high earnings expectations are becoming a potential hurdle for the market to overcome.

The unusually wide gap between trailing and forward multiples, however, does hint that returns may be subject to slowdown. The current spread is in the 96^th percentile - when that crossed into the fifth quintile (widest spread), year ahead returns on average slowed to just 4.5% (in the period studied, Jan. 1995 - Oct. 2026). Conversely, when the gap was narrower, returns commonly surpassed 10%. The takeaway is clear - lofty earnings bars can induce significant volatility in stock prices. When earnings hurdles are met or cleared, it can be smooth sailing for stocks, but sometimes consensus expectations are just too high.

Mega-cap Multiples are the Distortion - Stocks are Discounted

Despite significant de-rating since last fall, the S&P 500's mega-caps are still driving a lot of distortion in index-level absolute multiples. On an equal weighted basis, the S&P 500's trailing and forward multiples drop to 18.3x and 16.1x, respectively. While the trailing multiple is still higher than the forward multiple, both are discounted - at 0.2 and 0.5 standard deviations below the past 5-year average. Those multiples are still just 3.1 and 2.7 turns above respective 2022 lows, despite the equal weighted gauge surging 65.5% (13.4%) annualized over that stretch. That hints that a reasonably wide breadth of discounts still lurk under the surface.

In fact, the magnificent 7, while now trading as a group more than 1.4 standard deviations below recent 5-year averages, still carry multiples significantly higher than the rest of the index - helping along with a cohort of other high-flying tech stocks to keep headline absolute multiples high while still driving a significant portion of the index de-rating. The group carries a 23.7x forward multiple. This is down from 31.7x in October and 38.7x during the recovery from the covid-19 recession - and only a touch above the 2022 low of 22.3x. Still, that's well above the 17.7x for the other 493 companies (0.3 standard deviations below recent norms). Adding in the next three largest tech stocks - Broadcom, Micron and AMD - lowers the multiple for the cohort to roughly 21x, demonstrating the extraordinary earnings power, (and risk should AI tailwinds ease), for the mega-cap tech group.

Where do the Discounts Lie?

Looking across sectors, there's some wide divergences in multiples. We calculate each group's z-score by taking its preferred valuation metric and dividing by the index's valuation on that respective metric, comparing that to the recent 5-year average and standard deviation. Currently, communications is the most expensive of the 11 GICS sectors, followed by industrials and discretionary - each on a forward price/ebitda basis. Conversely, utilities (on a forward price/earnings basis) is the cheapest, followed by staples (on forward price/sales) and financials (price/book). Most sectors carry multiples within a stone's throw of norms - reflecting the more tame multiples at the index level currently.

Still significant portions of the index carry discounted multiples to recent norms, though the breadth of discounts is slightly less when accounting for the risk of high earnings expectations. Across the entire S&P 500, 64.3% of stocks are cheap relative to their recent 5-year average forward P/E, and 54.7% are discounted on a trailing basis. In fact, eight of 11 GICS industries have a majority of their constituents trading below norms on their respective preferred valuation metrics, led by utilities (90.3%, forward P/E), communications (73.7%, forward EV/EBITDA), materials (71.4%, EV/EBITDA) and staples (71%, EV/Sales). Conversely, tech (4.17%, EV/Sales), energy (42.1%, EV/EBITDA), and financials (48.6%, price/book) are the only sectors with a minority of companies currently discounted. It's worth noting that only health care and staples have fewer discounts on a forward, rather than trailing, basis. Utilities, real estate, materials and financials have the largest gap between percent of companies discounted on forward versus trailing preferred valuation metric.

Small Caps Sharply Discounted Relative to S&P 500 Despite Rally

The Russell 2000 has rallied 12.5% year-to-date, but that's done little to offset the steep discounts small caps enjoy relative to larger peers. Currently the small cap index trades at 1.44x forward sales, down from 1.55x back at the end of August. While this is still near the upper end of its historical range, it is still a severe discount compared to the S&P 500. Versus large caps, the gauge's 55.8% discount is 1.5 standard deviations below the average since 2000 and only a tad above the 60.1% discount the Russell 2000 enjoyed relative to the S&P 500 back in July 2025. Absolute multiple excess could explain some of the recent pullback in small cap stocks as rates rose - the last time the Russell 2000 commanded such a high multiple in 2021, zero interest rate policy (ZIRP) was still in place. Still, a relative discount to large caps could give small caps some leeway, as long as economic and revenue momentum remain intact.

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