A military conflict between the US and Iran is crippling the flow of oil around the world. Gas prices are rising. Inflation is back above 3 percent. Consumer confidence is declining, and many Americans are pessimistic about the economy. Yet the S&P 500 is up 29 percent over the past 12 months, hitting an all-time high last week. After being sold at the beginning of the war, the stock increases by 13 percent in 30 days. Despite the oil embargo and the threat to the entire civilization, investors have ignored it and continued to buy. The stock market seems out of touch with reality.
But there is logic at work: The stock keeps rising because the company’s profits have kept rising. If investors have learned to ignore President Trump’s chaos, it is not because they have forgotten the truth, but because this chaos has not reduced the company’s profits. Yes, there is a connection between the stock market boom and how ordinary Americans feel about the economy. But the stock market is not about the price of milk; it’s about how organizations do it, and right now they’re doing it really well.
Consider the so-called Magnificent Seven, the world’s most valuable technology giants, many of which reported quarterly earnings last week. Alphabet is now on track to make over 120 billion in profits this year alone. Nvidia is on pace to earn more than that, and has almost doubled its profit from last year. Meta’s most recent revenue was up 61 percent year over year. These companies together will make a profit of more than half a trillion dollars this year.
This thing goes beyond technology. About 80 percent of S&P 500 companies that have reported earnings so far have exceeded expectations. The average profit margin for S&P 500 companies is now at its highest level in 15 years, continuing a trend that began after the crisis. There are several possible reasons for this: Inflation and market consolidation have given companies more pricing power, productivity has been increasing (perhaps due to AI tools), and AI design has increased the technology’s profitability. But regardless of why it’s happening, future profits are a key ingredient to stock valuations, so stocks naturally go up, too.
This does not mean that today’s stock market makes perfect sense. Two weeks ago, the former shoe company Allbirds announced that it was relying on artificial intelligence, and its stock plummeted overnight. Since the onset of COVID, retail investors have also become accustomed to “buying the dip,” treating every sale as a clearance sale opportunity, regardless of geographic turbulence.
But there is plenty of evidence that investors are paying attention to key metrics. Companies that report disappointing sales numbers or miss earnings expectations are penalized by the market. When Nike reported in late March that it expected earnings to decline, the stock fell more than 15 percent on the day. Investors also see future threats to profits, selling shares in software-as-a-service businesses that could soon be disrupted by AI.
There is concern that the stock market’s price-to-earnings ratio—the amount that investors pay for each dollar of a corporation’s earnings—is high (though nowhere near the levels we saw during the dot-com bubble). But in general, investors seem to be responsible for the fact that the company’s income is not only high, but growing at a sustainable rate. The question now is how sensible the concept will prove to be. The war’s high energy prices are hitting the company’s bottom line and taking about $4 billion a month out of the pockets of American consumers. If this continues into the summer, businesses should prepare for lower consumer spending and weaker profits.
Investors are also playing heavily on AI growth, and the next year or so should reveal whether the valuations of various tech companies are overblown. Tech companies have been pouring money into building new data centers and AI chips, which may prove that public demand for their products will continue to grow, but it will be a big problem if AI fails to be as profitable as everyone promises.
For many investors, buoyed by years of growth, that’s a concern for another day. Although many people, including Trump, understand the stock market as a measure of the health of the economy, the gap between what investors see and what most people feel is wide and growing.
