You Won't Believe How Long These TWO "One-Time" Factors Can Impact Your Life! Find Out Now!

The US stock market reached another record high this week, raising questions about the sustainability of this rally. The current surge in corporate earnings expectations appears largely driven by two temporary factors: the explosive demand for AI chips and the ongoing war in Iran. Both elements are unpredictable and could change swiftly, potentially reversing the market's positive momentum.

This week, the S&P 500 Index (.SPX.US) climbed to new heights, having increased approximately 3% cumulatively since its peak in October last year. Meanwhile, the forward price-to-earnings (P/E) ratio of the index has significantly declined from over 23 times to below 20 times at one point, currently standing at around 22 times. Such a notable drop in the P/E ratio, alongside rising stock prices, is unprecedented in historical data since 1985. Historically, a sharp decline in the P/E ratio has coincided with a simultaneous fall in stock prices.

Despite the apparent improvement in valuation, The Wall Street Journal cautioned that this 'cheapness' could be an illusion. The boom in AI data center construction has driven up chip prices, while the war in Iran has resulted in soaring oil prices and profits for energy companies, which have elevated earnings expectations and contributed to the lowered P/E ratio. Should the demand for AI chips wane or tensions in the Gulf region ease, what seems like a reasonable valuation today may later appear excessive.

Unprecedented Divergence: Valuations vs. Stock Prices

The forward P/E ratio is calculated by dividing the stock price by Wall Street analysts’ forecasts of earnings per share over the next twelve months. When earnings expectations rise sharply while stock price increases remain modest, the P/E ratio naturally declines. This scenario is unusual; typically, a significant increase in earnings expectations would elevate shareholder sentiment, leading to higher stock prices and subsequently increasing rather than decreasing valuations.

Currently, two primary factors are propelling earnings expectations: the surge in AI demand and the financial impact of the Iran conflict. Both are seen as temporary catalysts, creating an unprecedented divergence between valuation and stock prices.

In the AI sector, the fluctuations in valuation are prominently illustrated by Micron Technology (MU.US), a leading manufacturer of high-speed memory chips crucial for AI applications. The company has seen its sales exceed market forecasts dramatically, driving significant price hikes and expanding profit margins. In October of last year, analysts projected Micron's earnings per share for 2027 to be $19. This figure has now skyrocketed to $101. Yet, while expected earnings have nearly quintupled, Micron's stock price has only slightly more than doubled, resulting in a notable decline in its P/E ratio.

The Wall Street Journal emphasized that a lower valuation does not necessarily indicate that a stock is cheap; it often reflects market expectations that current exceptionally high profits will be temporary. Historically, the memory chip industry is highly cyclical, and as more capacity becomes available, prices are likely to fall. Demand from data centers may also slow after initial needs are met.

Optimists argue that AI stocks are transitioning from speculative trading to real profit realization. Scott Chronert, Head of U.S. Equity Strategy at Citi, noted that the valuation of eight major technology and AI stocks was at its lowest price-to-earnings-to-growth ratio (PEG) since 2013. Conversely, pessimists believe that growth expectations remain overly optimistic, with forecasts for data center expansion exceeding reality. The shift from asset-light models to capital-intensive ones among major tech firms, along with the inherent uncertainties in Wall Street's earnings forecasts and the risks posed by renewed conflict with Iran, present multiple potential downturn threats.

The war in Iran has also distorted oil sector valuations. Oil prices surged due to successive sanctions on Persian Gulf oil exports by Iran and the United States. Projected earnings for the next 12 months of the three largest oil companies have risen about one-third since February, yet the forward P/E ratio for the oil sector dropped from 23.8 times before the war to 15.6 times. Following a ceasefire announcement, oil stock prices plummeted back to pre-war levels, despite continued earnings forecasts on the rise. Recently, reopening the Strait of Hormuz further depressed oil prices.

The oil futures market has long predicted a decline in oil prices. While the temporary boost in earnings is beneficial, what the market truly focuses on is sustained annual profit growth. The diminishing war premium illustrates the structural limitations of this benefit.

The current valuation of AI and oil stocks is based on the market's most optimistic expectations regarding the data center construction boom and the Iran conflict. However, this 'low valuation' is precarious: if the AI boom falters or if a peace agreement is reached in the Gulf, what appears inexpensive today could be deemed costly in hindsight. For investors, the current forward P/E ratio may not adequately account for the risk of an earnings slowdown that could arise in the upcoming year, providing limited buy or sell signals.