Did the US stock market miss the "good news" right in front of them? Earnings forecasts are unusually upgraded, strategists say: fundamentals are so strong it "doesn't seem real"

There is a clear divergence emerging between corporate earnings and the performance of U.S. equities: while fundamentals continue to improve, the market remains constrained by high interest rates and macroeconomic uncertainty. Earnings growth in some sectors is yet to be fully reflected in stock prices.

According to MarketWatch, Patrick Palfrey, Portfolio Strategist at Seaport Research Partners, stated that the current corporate earnings environment is exceptionally strong, and analysts' earnings expectations continue to be revised upwards. He pointed out that such a situation is extremely rare in history—"almost beyond the scope of normal possibility"—which underscores the resilience of corporate fundamentals.

However, the high-rate environment is still suppressing valuation multiples. Coupled with investor doubts about the sustainability of earnings, the market's response to these favorable fundamentals has been visibly muted. Palfrey noted that industrial and transportation stocks are especially prominent, with the fundamentals of relevant companies rapidly improving but stock prices yet to see corresponding returns, creating clear mispricing opportunities.

Meanwhile, interest rates and macro factors may continue to cause market disruption. Soaring oil prices are weighing on U.S. stock indices, the yield on the U.S. 10-year Treasury rising to 4.926%, and the Federal Reserve's rate decision next week remains unresolved, with the market currently giving about a 60% probability of a hike. Palfrey warned that if the Federal Reserve reiterates the need for rate hikes, it could deliver a short-term shock to the stock market.

Strong Earnings and Upward Revisions Reach Historic Extremes

Palfrey noted that S&P 500 components saw per-share earnings jump 55% year-over-year in the second quarter, and even excluding unrealized gains, earnings still rose 35%, which is “very, very robust.” The earnings growth was mainly driven by technology companies, especially the semiconductor sector. However, he emphasized that the overall corporate earnings environment remains healthy.

What deserves greater attention is the direction of analysts’ earnings estimate revisions. Palfrey explained that normally, earnings forecasts start the year at high levels and are typically revised downward as each quarter progresses. However, current analyst expectations are being persistently revised upwards, which significantly diverges from historical norms.

“Such a scenario is nearly outside the realm of normal possibility—which just demonstrates the strength of corporate fundamentals,” he said. This trend is partly due to ongoing construction of artificial intelligence infrastructure and the structural growth in energy demand.

High Rates Suppress Valuations as Market Mispricing Emerges

Despite fundamentally strong earnings, Palfrey also acknowledged that investors face real constraints when deciding what valuation multiples to assign to corporate earnings. He indicated that a high-interest environment increases capital costs and suppresses price-to-earnings ratios, being one of the main reasons behind the steady contraction in multiples this year. Additionally, concerns among investors about whether current strong earnings can be sustained further limit valuation space.

He cited as an example the sharp swings in software stocks earlier in the year: the market once heavily sold off these stocks over fears that AI could disrupt the traditional software industry—“before anyone had even conducted due diligence, every company had been found guilty”—and later, these stocks regained investor favor. This case illustrates that market sentiment-driven mispricing is not uncommon.

Seaport identifies “rational” and “irrational” price swings in the market by tracking the changes in per-share earnings expectations over three months relative to three-month stock price movements. Palfrey said that, at present, there is clear dislocation in the industrial and transportation sectors: fundamentals are rapidly improving, but stock prices have not sufficiently reflected this.

He believes one fundamental reason is that both capital and investor attention are monopolized by the tech sector. “Technology has not only absorbed all capital inflows, but has also captured all of investors’ attention.” This suggests that other sectors might, conversely, present undervalued opportunities.

Federal Reserve Decision Becomes the Key Near-Term Variable

Palfrey indicated that in this week's calls with institutional investors, interest rates were brought up repeatedly. In the past, investors would more often “wait and see” when facing interest rate risk. However, the issue is now being discussed more substantively, including concerns about rising capital costs, declining price-to-earnings ratios, and evolving demographics.

Regarding next week’s Federal Reserve rate decision, he warned that even though the market has currently priced in about a 60% chance of a rate increase, if the Federal Reserve reiterates inflationary pressures and the need for further hikes, it could still take the market by surprise.

“I think this will continue to throw cold water on the stock market in the near term,” Palfrey said. At present, investors are focused mainly on the AI construction theme in their daily trading and are relatively insensitive to macroeconomic data. However, once the rate narrative changes, the market’s bullish sentiment toward earnings fundamentals could still be suppressed.