Strong Earnings Drowning Out Negative Noise
Commentary Highlights:
Market Dissonance and Macroeconomic Friction: The equity market is characterized by a "cognitive dissonance" in which record 13.4% profit margins, terrific earnings results, and elevated expectations of continued earnings growth have pushed indices higher despite significant structural risks. While earnings remain robust, a lethargic labor market, a restrictive Fed (no interest rate relief), and rising prices at the pump ($4.45 per gallon) suggest the consumption side of the economy is under intensifying pressure.
The Industrialization of Technology: The Technology sector is undergoing a fundamental pivot away from asset-light software toward a capital-intensive "industrial infrastructure" model, with hyperscaler capex on track to exceed $900 billion by 2028. This shift introduces heavy depreciation schedules and rapid replacement cycles that complicate future Return on Invested Capital (ROIC), positioning "upstream" providers of silicon, power systems, and cooling technology as the most transparent value plays in the AI cycle.
Strategic Diversification and Embedded Exposure: Investors should recognize that significant exposure to high-profile private ventures like SpaceX and OpenAI is already embedded within the strategic stakes held by MegaCap Tech giants. Concurrently, gold remains in a secular bull market despite its correction to the $4,500 level, as aggressive bullion accumulation by global central banks serves as a strategic hedge against the defining volatility of the current geopolitical era.
Full Commentary:
Markets are often a test of your tolerance for cognitive dissonance. This is a classic case study for current times, where real risks that could torpedo the global economy exist, yet equity markets around the world push relentlessly higher. Don’t get me wrong, there is a constructive set of fundamental underpinnings justifying such a move, but I’d be lying if I didn’t admit to thinking there is an element of stocks ‘whistling past the graveyard’. More on both these elements below.
For the equity market, everything right now is coming up smelling like roses with the S&P 500 advancing more than +10% in April – led by the Mag7, which jumped +15% for the month. Last week was another positive week for the indices with the Nasdaq Composite logging a +1.1% weekly gain – now up more than +8.0% for the year and by an astounding +20% over a five-week span – the S&P 500 advanced +0.90% (fifth straight week of gains), and the Dow gained +0.55%. The S&P 500 is now +14% above its late-March lows and +5% above its level when the war began. This was the 12th strongest monthly gain since 1960, with flows playing a major factor in driving the rally – roughly $250 billion (according to data from Tier 1 Alpha) in forced buying from 401(k) flows and systematic strategies created a powerful non-discretionary tailwind for equity beta as those funds piled back into index-related products. However, the tailwind from many of the systematic strategies has now largely run its course.
On a near-term basis, the equity market has become overextended, with the S&P 500 and Nasdaq blowing far above their respective 200-day trendlines. A pause with prices consolidating around current levels would be more constructive for the sustainability of this bull market than a continued rip higher. Furthermore, the breadth of this rally has been lackluster with the S&P 500 equal-weight index closing the week down -0.3% and off around -1.0% from its peak. Another variable that seems to concern me more than it does the macro and market bulls is the fact that the national average price for a gallon of regular gasoline is up to $4.45, a jump of +$1.29 from year-ago levels, and up from $2.90 a gallon before the Iran conflict started at the end of February.
I know, I know, both the economy and the stock market have proven they can function just fine with a K-shaped makeup where the ‘haves’ pick up the slack from the ‘have-less’, but I am growing increasingly concerned that unless we get relief from the pressure at the pump soon, the consumption side of the economy is going to endure a level of contraction that will be too much to ignore.
Over the weekend the FT published an article titled ‘Oil market 1 month from crunch point…’ where they concluded that we are at an exhaustive tipping point in this regard, and that if the Strait of Hormuz remains shuttered by the beginning of June – now a month away – we are in for some serious problems when you look at the accelerating downward pressure on global crude inventories, which are on the precipice of falling below critical levels. “Traders and analysts warned that global stocks of crude, gasoline, diesel and jet fuel will hit critically low levels by the end of May, at which point prices will escalate rapidly.” Keep in mind that President Trump’s decision to end the bombing campaign means he intends to wait out Iran as its economy absolutely implodes, having already lost 40% of its GDP. The reason why markets don’t seem to care is because one-year oil futures are at $75 per barrel – investors seem to think that supplies will bounce back and most of the oil price surge will be reversed.
Yes, yes, I understand that I was one of those humble analysts forecasting about a month ago that if we got to mid-April with the Strait of Homuz still closed, we were almost certain to fall into a global recession given the spike in oil and other ancillary prices dependent on unencumbered trade flows through the Strait. At the risk of falling prey to the “boy who cried wolf” fable, I’m raising the alarm bells again. I’m not afraid to admit that this situation scares me, as I think the resilience of markets and the global economy is creating a level of complacency that can push each side beyond a point where we can’t undo the harm even if we wanted to. Having said that, it doesn’t mean that I am hitching an investment strategy to this sole risk factor. What’s obvious from the market action is that my initial thinking was wrong or mistimed, but I contend that this is a risk factor that can’t be ignored and must be gamed out in one’s investment strategy.
Before getting to the ‘good’ stuff, I want to highlight one more variable that has my attention from a cautionary standpoint, that being the labor market and how this ties into the Fed’s reaction function. Let’s start with the labor market. It continues to be a headscratcher to me that markets and traders have so much faith in the initially reported nonfarm payroll data. As if the economy really generated +178k net new jobs in March, after losing -133k jobs in February, and a total of +181k in all of 2025. I raise this retort because we just got the 2025Q3 numbers from the Business Employment Dynamics (BED) series, which is compiled by hard data via mandated unemployment insurance filings, not predicated on a low sample survey and a Birth-Death model. The BED data showed that in last year’s third quarter, employment fell by -159k and that followed a -321k contraction in Q2. What does the nonfarm payroll still show? A +70k gain in 2025 Q3 and +101k in Q2.
All I’m trying to get at is that the labor market is on far shakier ground than meets the eye. Not a new concept by any means, but low employment growth, low immigration growth, and a record low fertility rate aren’t a constructive combination for aggregate income growth, which matters for the nearly 70% of the economy made up of consumer spending. If not for the inflation pressures emanating from the Iran conflict, I’d be betting that the Fed would be much more willing to cut interest rates than stand pat, let alone entertain a shift to a tightening bias, which some Fed officials are now considering. The broadening difference of opinions within the Fed was on full display last week and is likely to add more market volatility to the system than dampen it. The futures market is now pricing in the Fed starting to hike rates again next year. The Fed may as well have just hiked its policy rate last week, based on the market reaction with the two-year T-note yield now basically back to pricing in a renewed policy tightening cycle – two-year Treasury yield at 3.97% vs. a Fed Funds Range of 3.50% – 3.75%. These are shades of the summer of 2008 when the Fed turned hawkish in tone as the oil price back then approached $150 per barrel. The rest was history.
Now that I got the list of concerns out of the way, let’s get to the good stuff. It cannot be denied that earnings estimates are on the rise and that, with three-fourths of the companies in the S&P 500 reporting their Q1 financial results thus far, average year-over-year EPS growth stands at roughly +15%, on track for a sixth straight double-digit quarterly gain. The consensus has moved up this year’s estimated EPS growth projection to +21% from +15% back in February, with analysts now expecting at least 20% YoY growth for every quarter this year. It’s hard to not be bullish the stock market if these estimates come to fruition.
While MegaCap Tech continues to lead the earnings train, it’s the results from the rest of the index constituents that are the pleasant surprise. The median stock is tracking a healthy 11% YoY EPS growth rate in 1Q – the highest level since 2021. Above-average guidance and revisions similarly point to improving breadth – the ratio of upward to downward revisions to 2026 EPS was 1.4x in April, with only 4 of 11 sectors seeing more downgrades than upgrades to estimates. But strong earnings are only part of the story; profit margins are the other part. The blended net profit margin for the S&P 500 for Q1 2026 is 13.4%. If 13.4% is the actual net profit margin for the quarter, it will mark the highest net profit margin reported by the index since FactSet began tracking this metric in 2009. The current record (since 2009) is 13.2%, set in Q4 2025.
This combination of growing earnings and record high profit margins justifies the S&P 500 trading at the upper end of its 14x – 23x P/E on forward earnings over the past 10 years. The Excel table below, put together by DataTrek, can be used as a scenario analysis to get a gauge on where the S&P 500 could trade based on P/E valuation and earnings assumptions. The baseline for evaluation is Wall Street's earnings estimates for 2026 ($325/share) and 2027 ($376/share). If the S&P were to maintain its 22x P/E multiple, it’s reasonable to expect it to trade between 7,152 (22 x $325 EPS for 2026) and 8,253 (22 x $376 EPS for 2027). This should be an investor's base-case assumption, with variations off it – at a 20x multiple, the range shifts to 6,502 – 7,502. Increase/decrease the multiple and or EPS growth estimates, and you can create alternative bear and bull case scenarios.
For the bull case to sustain its momentum, equity multiples must remain anchored at the upper bound of their trailing ten-year range. This burden of proof falls squarely on the Technology sector, which now commands 36% of the S&P 500. However, the data suggests a lack of conviction as the sector is not seeing the aggressive valuation expansion many would expect given the strong earnings results the group continues to put up. At 23.8x forward earnings, the sector is trading only slightly above its 10-year average of 22.8x and is actually compressed relative to its 5-year average of 25.8x. This creates a critical pivot point: Is Tech a 'value' opportunity, or is the market proactively derating the sector as it transitions to a more capital-intensive business model?
For nearly thirty years, MegaCap Tech enjoyed the ultimate "dream" business model: write the code once, distribute it globally at near-zero marginal cost, and harvest expanding margins through asset-light scalability. This was the hallmark of the software-as-a-service (SaaS) and digital advertising era—high network effects paired with minimal physical footprints.
That era is ending. The generative AI cycle is dragging Big Tech into a world defined by heavy industry. We have moved beyond the ephemeral realm of cloud subscriptions into the physical realities of land acquisition, power grid integration, liquid cooling systems, and massive GPU clusters. These data centers are, in effect, the 21st-century equivalent of the automated factory – vast, capital-heavy structures that require enormous upfront outlays and continuous maintenance. This shift is reflected in the staggering capex projections for the "hyperscalers," which are now on a trajectory to exceed $900 billion in 2028.
The irony of the current investment cycle is that these companies are spending record sums on a technology that may ultimately cannibalize the very software and internet profit pools that funded their ascent. This complicates the Return on Invested Capital (ROIC) equation. Unlike software of yesteryear, physical infrastructure entails heavy depreciation schedules, rapid replacement cycles, and high sunk-cost risks.
Furthermore, the competitive landscape is more fragmented and volatile than the "winner-take-most" dynamics of the early internet. With leadership rotating rapidly between entities like OpenAI, Anthropic, DeepSeek, and Google, the moats look less like reinforced concrete and more like shifting sand. Consequently, a valuation multiple anchored to "legacy" software margins may be carrying a hidden premium that doesn't account for the industrial-scale risks now being assumed.
Bottom line, MegaCap Tech is evolving from an asset-light service provider into a provider of industrial-scale AI infrastructure. While these remain formidable businesses, the quality of earnings is changing. Investors must now scrutinize depreciation policies and the potential for downward pressure on future ROIs as capex intensity reaches historical extremes. In our view, the investment conclusion remains clear: the most transparent value remains upstream. The "pick and shovel" providers – those selling the silicon, thermal management, power systems, grid infrastructure, and critical materials – are realizing cash flows today. Meanwhile, the platform giants still face the daunting task of proving that this unprecedented capital spend will generate a superior return in an environment of intensifying competition and technological disruption.
One side note on MegaCap Tech before closing up this week's missive, and this relates to an increasing number of questions I’ve been fielding up the IPO calendar later this year – specifically SpaceX, Anthropic, and OpenAI. My simple response at this time is, “I don’t know”. Do the businesses excite me? Yes. Is there a potential investment opportunity that could reward investors post-IPO or at the IPO? Yes. But none of them have filed S-1s yet, so there is very little actual data to go on for analysis. Furthermore, it’s unknown at this time what valuation any of them will come public at. Buying a great business at an awful valuation can make it a terrible investment. What you pay for an asset is extremely important for the return profile you get as an investor.
What we do know for sure is that no one investing in these companies at current valuations will be getting as good a deal as some of the MegaCap Tech companies that were early investors in these entities. Take Alphabet (Google) for example – they invested $3 billion into Anthropic in 2023, which is now estimated to be worth $112 billion. They invested $1 billion in SpaceX back in 2015, which is now valued at $107 billion.
Amazon is estimated to be the largest single investor in Anthropic, having committed $8 billion across multiple investing rounds. Amazon also owns just under 5% of OpenAI, which pales in comparison to Microsoft, which is the largest stakeholder at nearly 27%. So, my answer to investors looking to participate in the excitement of these IPO’s later this year is to check your statement, as you may already have more exposure than you realize.
I close with a thought on gold, an asset class that is down, but not out. Gold is trading around the $4,500/oz level – down about $1,000/oz or 20% from its high and has lost some its shine from earlier this year. I remain of the view that gold is in a secular bull market and its recent correction is a good opportunity for those investors underexposed to the asset class to add to it. I say that because the most important driver of demand remains intact. Central banks around the world (especially in the Emerging Markets space) are still bulking up on bullion. The central banks of Poland, Turkey, India, and China remain large-scale buyers. Since the U.S.-Iran war broke out in late February, we have seen a long lineup of active buyers ranging from China to Poland to the Czech Republic to Uzbekistan — in fact, the PBOC bought more gold in March, and at a pace we have not seen in more than a year (as per the World Gold Council). I find this to be highly encouraging, even though the yellow metal is off the early-year peak. As Adam Glapinski, the governor of the National Bank of Poland, aptly put it:
“Recent market developments, driven by the instability in the Middle East, have reinforced our view that instability has become the defining feature of the global economy. I would reiterate the importance of diversifying foreign reserves and the role of gold as a strategic asset.”
The articles and opinions in "Capital Market Musings and Commentary" are for general information only, and not intended to provide specific investment advice. Performance, dividends and other figures have been obtained from sources believed reliable but have not been audited and cannot be guaranteed. Past performance does not ensure future results. Investing inherently contains risk including loss of principle. Advisory services offered through Casilio Leitch Investments, an SEC registered investment advisor. Copyright © 2023 Casilio Leitch Investments. All Rights Reserved.