Behind the Record Highs in the U.S. Stock Market: How Long Can Two “One-Time” Factors Last?

The US stock market hit another record high this week, but the foundation supporting this rally is being questioned. The current surge in corporate earnings expectations is almost entirely driven by two one-off factors: the explosive demand for AI chips and the war in Iran — both of which are clearly temporary and could reverse at any time.

This week, $S&P 500 Index (.SPX.US)$ Reaching a new high, it has risen by approximately 3% cumulatively since the peak in October last year. Meanwhile, the forward price-to-earnings (P/E) ratio of the index has sharply retreated from over 23 times to below 20 times at one point, and currently stands at around 22 times. This combination of a significant decline in the P/E ratio alongside rising stock prices has never been observed in historical data since 1985—every previous instance of such a sharp drop in valuation was accompanied by a simultaneous fall in stock prices.

This seemingly ‘improved valuation’ has reassured investors, but The Wall Street Journal warned that the current ‘cheapness’ might just be an illusion. The boom in AI data center construction has driven up chip prices, while the war in Iran has significantly boosted oil prices and energy company profits, raising earnings expectations and lowering the P/E ratio. Once the AI boom reverses or tensions in the Gulf ease, what appears to be a reasonable low valuation today may later seem expensive.

The S&P 500 Index’s current forward P/E ratio is about 22 times, which, despite being lower than the peak in October last year, remains far above the long-term average of 16 times. There is clear divergence among bulls and bears regarding whether the current valuation is sustainable.

Unprecedented: New highs in stock prices coexist with declining valuations

The basic logic of the forward P/E ratio is to divide the stock price by Wall Street analysts’ forecasts of earnings per share over the next 12 months. When earnings expectations rise significantly while stock price increases are relatively limited, the P/E ratio naturally declines.

In the past, a significant increase in earnings expectations usually lifted shareholder sentiment, and stock prices typically rose even more, thus increasing rather than decreasing valuation. A sharp drop in the P/E ratio almost always signaled bad news — often because recessions caused earnings expectations to decline faster than stock prices fell.

This time, there are two main reasons driving the surge in earnings expectations: first, the explosion in AI demand has driven up chip prices; second, the war in Iran has significantly boosted energy company profits. Both are seen by the market as temporary factors. This combination has created an unprecedented divergence between valuation and stock prices in history.

AI Chips: Cyclical Concerns Linger Behind Soaring Profits

The valuation changes in the AI sector are most prominently reflected in memory chip manufacturer $Micron Technology (MU.US)$ Micron Technology. The company produces high-speed memory chips required for AI, and the surge in its sales has far exceeded market expectations, driving significant price hikes and expanding profit margins.

In October of last year, the median analyst forecast for Micron’s 2027 earnings per share was $19; now, this projection has surged to $101. However, while expected earnings have nearly quintupled, its stock price has only slightly more than doubled, causing a significant decline in the price-to-earnings ratio.

The Wall Street Journal noted that a lower valuation does not necessarily mean the stock is cheap, but rather reflects market expectations that the current ultra-high profits will be temporary. The memory chip industry has historically been highly cyclical, and as more capacity comes online, prices will eventually fall; demand from data centers will also slow after being satisfied.

Optimists argue that AI stocks are transitioning from speculative trading to genuine profit realization. Scott Chronert, Head of U.S. Equity Strategy at Citi, pointed out that the valuation of eight major technology and AI stocks earlier this week, measured by the price-to-earnings-to-growth ratio (PEG), was at its lowest level since 2013.

Pessimists, however, believe growth expectations remain overly optimistic, with forecasts for data center expansion far exceeding reality. Major tech companies have shifted from asset-light models to capital-intensive ones, compounded by the inherently large margin of error in Wall Street earnings forecasts and the underestimation of risks posed by renewed conflict with Iran, creating multiple downside threats.

Oil Stocks: War Premium Fading, Valuation Compression Unsustainable

The distortion caused by the Iran war on oil sector valuations cannot be overlooked. Oil prices surged due to successive restrictions on Persian Gulf oil exports by Iran and the United States. The projected earnings for the next 12 months of the three largest oil giants are about one-third higher than at the end of February, while the forward price-to-earnings ratio of the oil sector dropped from 23.8 times before the war to 15.6 times.

However, following the ceasefire announcement, oil stock prices promptly plunged, erasing gains back to pre-war levels, even though earnings forecasts continued to rise. News of the reopening of the Strait of Hormuz further depressed oil prices on Friday—despite Iran’s claim on Saturday that the strait had been closed again, by which time the market had already closed.

The oil futures market had long signaled an eventual decline in oil prices. For shareholders, while the temporary boost in earnings is positive, what the market truly focuses on is sustained annual profit growth. The rapid fading of the war premium clearly demonstrates the structural limitations of this benefit.

Pricing Based on Two Key Themes May Be Losing Validity, Low Valuations Carry Risks of Backlash

The current pricing of AI stocks and oil stocks is based on the market’s most optimistic expectations regarding two core themes: the data center construction boom and the Iran war. This makes the overall market appear cheaper on paper than before.

However, the vulnerability of this “low valuation” is evident: if the AI boom turns into a bust, or if a peace agreement is reached in the Gulf region, what seems inexpensive today may retrospectively appear costly. For investors, the current forward price-to-earnings ratio based on the next 12 months does not adequately reflect the risk of an earnings slowdown that could occur a year from now, offering very limited buy or sell signals.

Editor/KOKO