Research & Insight

The heady optimism in forecasted earnings is hiding in aggressive expectations for profit margins. The rise in market valuations has been much more tightly linked to those elevated margins - and expectations for even higher margins next year and the year after - than investors may realize. If the widely held belief that public companies will perpetually become more profitable begins to falter, the steep valuation premium that has been priced into U.S. large-cap stocks over the past decade may evaporate.

The primary drivers of major stock market declines - extended valuations, a sharp rise in interest rates, and growing recession risks - are rarely as elevated, in combination, as they are today. Even a “small r” recession could lead to a deep stock market decline, and the bulk of those losses could occur before the recession is even recognized.

As central banks have shifted to almost purely discretionary monetary policies, investors have lost the anchor of observable economic data. Rising rates of inflation are already more persistent than anyone would have guessed, and the first global monetary tightening cycle in more than five years is likely to begin, amid record market valuations.