The Record-Breaking U.S. Stock Market’s False Foundation: How Long Can Two Major "One-Off" Factors Last?

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US stocks hit new record highs again this week, but the foundation supporting this rally is being questioned. The current surge in corporate earnings expectations is almost entirely driven by the one-off benefits of exploding AI chip demand and the Iran war—both of which are clearly temporary factors that could reverse at any moment.

This week, the S&P 500 index climbed to new highs, up about 3% from the peak last October. Meanwhile, its forward price-to-earnings ratio dropped sharply from over 23 times, dipping below 20 times at one point and now sitting at about 22 times. This combination of a sharp drop in P/E alongside rising stock prices has never appeared in historical data since 1985—every past instance of such a steep decline in valuation was always accompanied by a simultaneous drop in stock prices.

This apparent "valuation improvement" brings comfort to investors, but The Wall Street Journal warns that today's "cheapness" may be an illusion. The AI datacenter construction boom has driven chip prices to soar, and the Iran war has sharply raised oil prices and energy company profits. Together, these factors have raised earnings expectations and lowered P/E ratios. Once the AI boom reverses or the Gulf situation eases, the seemingly reasonable low valuations today may turn out to be expensive in retrospect.

Currently, the S&P 500 index's forward P/E ratio is about 22 times. Although it's down from the peak last October, it's still far above the long-term average of 16 times. There is a clear divide between bulls and bears over whether current valuations are sustainable.

Unprecedented: Record Highs in Stock Prices with Shrinking Valuations

The basic logic behind forward P/E is dividing stock prices by Wall Street analysts’ forecasted earnings per share over the next 12 months. When earnings expectations are significantly revised upward while stock price increases are limited, the P/E ratio naturally declines.

In the past, a big upward revision in earnings expectations typically lifted shareholder sentiment, driving stock prices even higher and raising valuations instead of lowering them. A sharp drop in P/E almost always signaled bad news—usually a recession where earnings expectations fell faster than stock prices.

This time, there are two main drivers behind the surge in earnings expectations: First, the explosion in AI demand pushing chip prices higher; second, the Iran war greatly boosting energy company profits. Both are seen by the market as temporary factors, creating an unprecedented divergence between valuation and stock prices in history.

AI Chips: Surging Profits Hide Cyclical Risks

The changes in AI sector valuations are most evident in memory chip maker Micron Technology. The company produces high-speed memory chips needed for AI; sales have soared far above market expectations, allowing for big price increases and expanded profit margins.

Last October, the median analyst forecast for Micron’s 2027 EPS was $19; now that forecast has jumped to $101. Even as forecasted earnings grow nearly fivefold, its stock price has only more than doubled, causing the P/E ratio to plummet.

The Wall Street Journal notes that lower valuations don’t mean stocks are cheap—it reflects the market's belief that current super-high profits are temporary. The memory chip industry has always been highly cyclical. As more capacity comes online, prices will inevitably fall; datacenter demand will also slow once needs are met.

Optimists believe AI stocks are moving from speculative trading to genuine profit reality. Citi’s US equity strategy chief, Scott Chronert, points out that by the P/E-to-growth ratio (PEG), valuations for the eight major tech and AI stocks at the start of the week were the lowest since 2013.

Pessimists argue that growth expectations are still too high, datacenter expansion forecasts are far beyond reality, big tech firms have shifted from asset-light to capital-intensive models, Wall Street earnings forecasts notoriously have large errors, and the renewed risk of war with Iran is being overly ignored by stock investors—multiple factors threaten downside risk.

Oil Stocks: War Windfall Fades, Compressed Valuations Unsustainable

The distortion in oil sector valuations from the Iran war is equally significant. Oil prices soared because Iran and the US restricted Persian Gulf oil exports. The next 12-month earnings estimates for the three major oil giants are about one-third higher than at the end of February; the sector’s forward P/E dropped from 23.8 times pre-war to 15.6 times.

However, stocks in the oil sector quickly fell back to pre-war levels as soon as the ceasefire news emerged, even as earnings expectations continued to rise. News that the Strait of Hormuz had reopened pushed oil prices down further on Friday—even though Iran later declared on Saturday it had closed the strait again, the market was already closed by then.

The oil futures market has long signaled oil prices will eventually fall. While shareholders might benefit from temporary profit spikes, what matters to the market is sustainable profit growth year after year. The speed at which the war windfall fades clearly reveals its structural limitations.

Two Key Themes Priced-In May Fail; Low Valuations Risk Reversal

Current pricing of AI and oil stocks is based on the market’s most optimistic expectations for datacenter construction and the Iran war. This makes the overall market look cheaper than before on paper.

But the fragility of these "low valuations" is obvious: If the AI boom turns to bust or a peace deal is reached in the Gulf, today’s bargains could very well look expensive in hindsight. For investors, relying on the next 12 months' forward P/E fails to properly reflect the risk of slowing earnings a year from now, offering very limited trading signals.

Risk disclosure and disclaimerThe market has risks, invest with caution. This article does not constitute personal investment advice, nor does it consider the special investment objectives, financial status, or needs of individual users. Users should consider whether any opinions, viewpoints, or conclusions in this article suit their specific circumstances. Investing accordingly is at your own risk. ```