US corporate earnings growth is slowing. Unless it picks up again, stocks will become overvalued.

The optimism in the markets in the wake of the US elections has faded. Donald Trump’s return to the White House raised hopes that the US equities market would flourish and that US companies would see firm revenue growth. The reality is much less exciting. In the last few weeks, the earnings trend has turned and the deceleration has become more marked since the end of January, with earnings growth falling from 15% to 10% across all sectors. The slowdown is the result of geopolitical tensions, uncertainty about US growth and tariffs, and increased inflation expectations.

Greater uncertainty about the economic cycle

The president’s first measures, targeting Canada, Mexico and China, revived the prospect of a trade war. His policy is to use tariffs to exert strategic leverage in order to achieve a combination of trade, industrial and political objectives and one clear end goal: to finance tax cuts. Concern about inflation and jobs has caused consumer sentiment to fall back to its pre-election level.

Among manufacturers, worries about tariffs and their disruptive effect on supply chains are also affecting business confidence. These doubts could put the brakes on capital expenditure, which in turn could hamper growth in the first quarter of 2025. One thing remains certain, which is that the economic cycle is now less predictable. However, the equity market needs predictability if it is to maintain its momentum at a time when valuations remain stretched.

The new president’s political agenda is naturally stagflationary, and has pushed up inflation expectations. As a result, the Fed could be forced to tighten monetary policy, whereas the markets are currently expecting an easing.

Robust earnings, but the trend is turning

In the fourth-quarter 2024 earnings season, earnings growth was above its historical average. The S&P 500 showed annual earnings growth of 16%, the highest level in three years. After these earnings announcements, however, US equities fell, caught between investors’ overexposure to the tech sector and the fact that earnings expectations were already high. The US 2025 price/earnings to growth (PEG) ratio is now 2.2, i.e. a price/earnings (P/E) ratio of 22x divided by earnings growth of 10%. The PEG ratio has therefore increased since the start of the year, when it was 1.46 based on a more optimistic earnings growth estimate of 15%.

Conversely, European stocks have been more resilient on average since their fourth-quarter earnings announcements, due to more favourable earnings momentum than in the US. Whereas earnings growth forecasts have fallen for S&P 500 stocks, they have held steady at around 8% for European companies.

In valuation terms, the S&P 500 is trading at a lofty 22 times forward earnings. The premium is due to the index’s heavy exposure to the tech sector, which has a weighting of 42%, including the “Magnificent 7”. However, the S&P 500 Equal Weight index, which adjusts for that bias, shows a forward P/E ratio of 18x, only slightly above its average in the last 10 years. The Magnificent 7 are trading at 31x forward earnings, also slightly above their 10-year average.

Protection strategies

Although circumstances may slow the US equity rally in 2025, earnings growth is likely to remain in the double digits. This suggests that the stockmarket will turn in a positive performance, although it will find it hard to replicate the gains seen in 2024. At this stage, it appears that only a major negative surprise is capable of triggering a correction.

Accordingly, we still favour US equities, although we are taking a cautious approach. Protection strategies, particularly those involving options, appear to be an effective way of gaining upside exposure while limiting the impact of volatility.

Any forecast, projection or target, where provided, is indicative only and is not guaranteed in any way.