This article is written exclusively for Investing.com
Earnings season is approaching and it could prove to be one of the most critical earnings seasons in recent years, especially with the markets at record highs and valuations at peak levels. This means that if stocks are to keep moving up, this earnings season in particular must be not only good, but better than expected, so estimates can be revised higher.
The stock market isn't cheap. , which is currently trading about 21 times forecasted 12-month earnings estimates. More importantly, the multiple of the price has been relatively constant for about a year now, trading between 20 and 23 times the estimates. This is super important because stocks can only rise from here if multiples continue to grow without positive earnings revisions. Given the recent trend, higher multiples seem unlikely.
Multiple expansions and upward revisions
The S&P 500 is currently trading at 21.2 times estimated earnings for the next 12 months of approximately $200 per share. But what is clear is that the PE ratio for the S&P 500 has been above 20 since May 2020. But more importantly, after peaking at around 23, it is slowly moving down, suggesting the market is going through a period of PE compression.
The S&P 500 continued to rise, despite the PE ratio declining as earnings estimates have risen sharply. As of May 2020, estimates of future 12-month earnings for the S&P 500 have risen from $139.50 to about $200, with gains of more than 43%. Unless earnings estimates continue to rise, it will be difficult for the stock market to sustain these high valuations, especially if the PE ratio continues to fall.
Slowing growth
To make that happen, Second quarter results should not only come in as expected, but much better than expected as earnings growth will slow dramatically from now through the end of 2022. Earnings growth for the next 12 months is currently 21.3%. However, if we look at the estimates for the next 18 months, growth will fall to around 11.5%.
Priced to perfection
The declining PE ratio may reflect expectations for slowing growth rates likely to come in the coming months. But if the PE ratio falls, it will be up to positive earnings revisions to keep the S&P 500 afloat. If the second quarter doesn't perform or, worse, disappoint, that could be a problem for the perfectly priced stock market.
It doesn't get much better for the , with that index experiencing many of the same headwinds as the S&P 500. High PE ratio and slowing growth rates pose the same threat here as well. Like the S&P 500, the NASDAQ should see its earnings estimates rise. It requires a strong performance from the second quarter to keep the uptrend in place. As a result, this could prove to be one of the most critical earnings seasons to come in a while. If all goes well, the stock market rally may continue for a while. But if it turns out to be even a hint that's weaker than expected, it could be a big problem for what's to come.
