Inflation remains pesky, interest rates have drifted higher, and we’re at war with Iran. Yet, stock prices keep flirting with record highs. What’s going on? The short answer: corporate America is making a lot of money.
S&P 500 companies continue to report extraordinarily strong earnings growth, and analysts continue to forecast further increases—oftentimes significant increases. First-quarter earnings grew approximately 20% year-over-year, according to LPL Research. And if we include some unusually large investment gains reported by several technology companies, LPL estimates earnings grew around 29%
Second-quarter results surprised even more to the upside. With just a handful of companies yet to report, LPL said second-quarter earnings are tracking over 30%, excluding the investment gains. Perhaps more importantly, the strength is broadening: ten of eleven S&P sectors were reporting year-over-year earnings growth, with eight posting double-digit gains.
Please note how unusual this is. We don’t see earnings growth like this unless we are coming out of a recession or we’ve experienced a shock to the system. Since we’re about to start the NFL season, you might say that it would be akin to Bo Nix throwing 60 touchdowns this year and leading the Broncos to a 17-0 record. That’s not in my crystal ball, Bronco fans. But it should give you an idea of just how powerful corporate earnings have been.
And here’s something even more interesting: stock prices arguably haven’t kept up with earnings. The S&P 500’s forward price/earnings ratio has actually declined from earlier this year while stock prices have been rising.
I would not call today’s stock market cheap. A forward P/E of roughly 20 is slightly above its long-term average. But this is also nothing resembling the speculative excesses of the dot-com era, when many companies traded at extraordinary valuations despite having little or no earnings.
As always in markets, there are legitimate concerns today, particularly about the enormous amounts of capital being committed to the buildout of AI data centers. Will the hyperscalers eventually earn an adequate return on the hundreds of billions of dollars being invested in data centers, chips, energy infrastructure, and AI models? We simply don’t know yet. But for now, this bull is bucking hard—and earnings are providing the horsepower.
Meanwhile, interest rates have been trending higher. Is that because of inflation? Strong economic growth? Massive federal borrowing? The enormous capital requirements associated with the AI buildout? It’s probably some combination of all four.
The U.S. government must finance enormous fiscal deficits while the hyperscalers are raising extraordinary amounts of capital for AI infrastructure. Given the increased need for debt, investors are increasingly demanding higher yields to commit capital to buy bonds.
Unfortunately, this isn’t particularly good news for housing. The average conventional 30-year mortgage recently stood at approximately 6.65%, according to Freddie Mac.
Ironically, it’s possible that a Fed rate hike in September could help bring long-term interest rates down. That might sound contradictory, but remember: the Federal Reserve only directly controls the short-term overnight interest rate. The bond market determines the longer-term rates.[1]
If bond investors believe that the Fed is serious about controlling inflation, then inflation expectations could fall—and long-term Treasury yields could fall with them. Conversely, if investors believe the Fed is falling behind the inflation fight, they might demand higher yields for lending money for ten years or longer.
This brings us to the Fed and the money supply.
[1] The Fed still has about $4.55 trillion on its balance sheet – arguably affecting long-term rates somewhat.
I wrote to you a few months ago arguing that a short war with Iran would not create lasting inflation simply due to higher oil and gas prices.[2] I was—and remain—more concerned about the excess money that remains with us from the overspending during COVID.
The pandemic created an extraordinary emergency, and policymakers responded accordingly. Congress authorized massive fiscal spending while the Federal Reserve complied by buying bonds and simultaneously holding the short-term rate near zero for an extended period. Those policies were intended to prevent a financial and economic collapse, and to be fair, they helped accomplish that objective.
But profligate monetary and fiscal policies have consequences. One consequence was an enormous increase in liquidity and money circulating through the financial system. This is measured by the Fed as M2. Please see the graph below. This is what caused inflation. And this is why inflationary pressure remains with us.
[2] Financing wars become inflationary when government spending demands large amounts of resources. So far, we’ve spent anywhere from $37.5 to $100 billion, depending on how you measure it. That’s not insignificant.
One reason policymakers felt justified in the fiscal and monetary Covid response was that we did something similar after the financial crisis of 2008—yet we did not experience the kind of consumer inflation that followed COVID. The excess funds found their way onto bank balance sheets and did not get into the general money supply. Creating reserves in the banking system is very different than putting spendable money directly into consumers’ checking accounts.
Following the 2008 financial crisis, banks were repairing their balance sheets, lending standards tightened, households reduced their borrowing, and much of the newly created liquidity remained within the financial system.
COVID was different. This time, extraordinarily aggressive monetary policy was paired with extraordinary fiscal policy: stimulus checks, enhanced unemployment benefits, the Paycheck Protection Program, and other programs transferred enormous sums directly into the private economy.
The Covid responses simply resulted in too much money chasing too few goods and services. Much of that excess liquidity remains in the money supply, as you can see from the graph.
And this brings us to interest rates.
Higher interest rates tend to slow inflation. When borrowing becomes more expensive, consumers borrow less, businesses become more selective about capital projects, banks become more cautious, and economic activity tends to slow. That reduces demand and, over time, can reduce inflationary pressure.[3]
At its July meeting, the Federal Reserve declined to raise its overnight rate. Many bond investors concluded that the Federal Reserve was not serious about fighting inflation and responded by selling bonds causing interest rates to rise.
For now, the bond market remains constructive, though there has been a repricing of debt higher. Yardeni Research likes to point out that the 10-year yield remains below the nominal GDP rate (real GDP plus inflation) – historically meaning that there is no cause for panic. But if the Fed won’t do the dirty work of restraining inflation, the bond market may end up having to do it for them. Call them the “bond vigilantes” if you’d like.
[3] In a fractional reserve banking system like ours, less borrowing means less M2 in the system because banks “create money” when they lend deposits.
Not necessarily. I’ve argued in these missives before that reasonably higher interest rates are actually healthy for an economy. When money is virtually free, questionable projects get financed. “Bridges to nowhere” get built. Management teams are tempted to pursue low-yielding investments simply because money is cheap to borrow. Conversely, when borrowing money costs more, then borrowers have to think more soberly: will this investment generate a return greater than the cost of financing it? That’s healthy capitalism.
There is, however, another side to the equation for investors. As bond yields rise, bonds become increasingly competitive with stocks. An investor who can earn an attractive return from a high-quality bond has less incentive to assume the additional uncertainty of stocks.
That doesn’t mean money suddenly exits the stock market. But at the margin, higher bond yields raise the hurdle that stocks must clear. And that may partly explain why stock-market valuations have compressed even while stock prices have risen.[4]
One last bit of perspective: today’s interest rates feel high primarily because we spent nearly fifteen years living in an extraordinarily low-rate world. Historically, today’s rates are normal. Those of you who were adults living through the late 1970s and early 1980s certainly remember that. The 10-year Treasury yield approached 16% in September of 1981.
[4] I could also get into a discounted cash-flow model of pricing stocks and why higher interest rates should result in lower stock prices, but that would make a dry topic even worse!
Corporate earnings are exceptionally strong and, for now, providing powerful fundamental support for stock prices. At the same time, persistent inflation, enormous government borrowing, and extraordinary capital demands from the AI buildout are putting upward pressure on interest rates.
That’s the tension I’m watching.
I don’t believe higher interest rates, by themselves, will end this bull market. But if rates continue to climb, then bonds will become increasingly attractive…and stock valuations could face further headwinds.
More importantly, markets don’t move because of any single variable. Earnings, interest rates, inflation, valuations, fiscal and monetary policy, geopolitical events, and investor psychology all interact. These variables cause optimists and pessimists to show up at the market every day to do business with each other.
Our job isn’t to predict every twist and turn. It’s to understand the forces at work, manage risk intelligently, and make sure that we help keep you on track to reach the deeply important goals that you have set in your financial goals.
As always, stay patient, stay disciplined, and stay invested.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
Todd Kirsch is the founder of Kirsch Wealth Advisors and serves as an advisor to individuals, families, and business owners navigating complex financial and estate planning decisions.His philosophy is grounded in a patient and disciplined approach to planning. He and his team help clients stay away from the media headlines and focus on their long-term goals. He believes that the purpose behind money is what’s most important. He encourages clients to use their wealth intentionally to support their lives, families, charities, and long term legacy.
Holding both a Juris Doctor (JD) from Boston University and the CERTIFIED FINANCIAL PLANNER ® certification along with many years working in the insurance industry, Todd brings a combination of legal insight and comprehensive financial planning expertise to his clients. This background allows him to thoughtfully integrate investment strategy, retirement planning, and estate planning into a coordinated, values aligned approach.
Todd has a wife, three adult children, and the coolest dog ever named Muddy.
Todd has been deeply influenced by both eastern and western thought on the energy and spirit behind money. He doesn’t bring it up, but feel free to ask him about these thoughts.
Todd Kirsch is the founder of Kirsch Wealth Advisors and serves as an advisor to individuals, families, and business owners navigating complex financial and estate planning decisions.His philosophy is grounded in a patient and disciplined approach to planning. He and his team help clients stay away from the media headlines and focus on their long-term goals. He believes that the purpose behind money is what’s most important. He encourages clients to use their wealth intentionally to support their lives, families, charities, and long term legacy.
Holding both a Juris Doctor (JD) from Boston University and the CERTIFIED FINANCIAL PLANNER ® certification along with many years working in the insurance industry, Todd brings a combination of legal insight and comprehensive financial planning expertise to his clients. This background allows him to thoughtfully integrate investment strategy, retirement planning, and estate planning into a coordinated, values aligned approach.
Todd has a wife, three adult children, and the coolest dog ever named Muddy.
Todd has been deeply influenced by both eastern and western thought on the energy and spirit behind money. He doesn’t bring it up, but feel free to ask him about these thoughts.