Stocks priced for ‘sunshine and rainbows’ now face earnings test

The stakes have rarely been higher. The S&P 500 Index shook off a tough start to the year and now is up more than 10% in 2026. But the move feels fragile since the typical drivers of the rally — the technology behemoths known as the Magnificent Seven — are barely participating, with an index tracking the group gaining just 3.2% this year. If that continues, the S&P 500 will need strong performances from its other 493 stocks to continue powering the index through the second half.

Second-quarter earnings season kicks off Tuesday with reports from Wall Street giants Goldman Sachs Group Inc. and JPMorgan Chase & Co. Profits from S&P 500 firms are expected to rise 24% in the three months through June, data compiled by Bloomberg Intelligence show, which would be among the best readings ever outside of recoveries from major recessions.

The problem is those rosy projections are running up against sticky inflation, climbing energy costs and rising odds of interest rate hikes by the Federal Reserve, all of which could eat into profit margins. And with the stock market trading near all-time highs and valuations looking stretched, the setup suggests little room for error.

“The market is in an unusually delicate position,” said Violeta Todorova, senior research analyst at Leverage Shares. “This is a season where in-line will be treated as a disappointment, particularly in the names that have led the rally.”

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Companies may end up surpassing sell-side’s profit estimates like they did last quarter, but there’s no guarantee. Artificial intelligence will likely be a major focus again, with eyes on which tech firms are seeing payoffs from their heavy spending. In addition, traders are looking for guidance from companies in capital-intensive industries about whether they’re continuing to invest in growth.

“There’s just less room for companies to blow away investors — they expect sunshine and rainbows and that’s what companies are going to have to deliver,” said Anthony Saglimbene, chief market strategist at Ameriprise Advisor Services. “The bar is super high.”Here are the key themes investors are watching this earnings season:

Peak Expectations

Wall Street analysts have been aggressively raising their earnings estimates for S&P 500 companies, with firms representing just shy of 64% of the benchmark being revised higher in May, a record, according to Ned Davis Research. The number is still elevated but slipped to 63.6% in June. The question is whether that can continue.

“High valuations tend to not be a problem when earnings growth is strong, but that does not mean the market is immune from a correction once EPS growth inevitably slows,” Ed Clissold, chief US strategist at Ned Davis Research, wrote in a July 7 note.

Large swaths of the market are seeing earnings growth cool, including stocks in the consumer discretionary and staples, financials, industrials and healthcare sectors. On the other hand, chipmakers are poised to post earnings expansion of 136% from a year ago as cash pours in from AI spenders, according to data from BI.

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The setup for sectors that are still seeing accelerating growth and sharp share-price gains, like semiconductors, is “precarious” and the companies had “really better deliver” to meet heightened expectations, said Marta Norton, chief investment strategist at Empower.

“What analysts are putting out there is really astonishing,” she said.

AI Bills

Tech stocks are center stage this earnings season as the biggest drivers of market rallies in the US, Taiwan and South Korea. In the US, information technology companies are expected to post 67% profit growth, second-best among S&P 500 sectors after energy at 118%, BI figures show.

But investors have been hard to impress. Blowout results from Samsung Electronics Co. and Micron Technology Inc. failed to push semiconductor stocks higher amid concerns of bloated valuations. The MSCI World Semiconductors & Equipment index hit a record on June 22, but is down 6.1% since then, making next week’s reports from ASML Holding NV and Taiwan Semiconductor Manufacturing Co. key.

Meanwhile, results in a few weeks from the big spenders on AI infrastructure — Alphabet Inc., Amazon.com Inc., Meta Platforms Inc., Microsoft Corp. and Oracle Corp. — will offer guidance on whether their investments are paying off. The group was among the biggest winners in the AI trade until recently, when investors turned skeptical on how much cash is heading out the door.

Bloomberg

The largest US AI companies are expected to shell out more than $700 billion in capital expenditures this year. However, changes in spending are a double-edged sword. A decline could be well received, but pulling back too hard could spook investors by showing a lack of confidence in those investments paying off.

“If you start to see too much debt issued, then the market will say this is too much,” said Daniel Murray, deputy chief investment officer at EFG Asset Management. “But equally, if you don’t have any capex, the market wouldn’t like that either.”

That said, so-called AI hyperscaler stocks look “way oversold,” making their valuations attractive, according to Jay Hatfield, chief executive officer at Infrastructure Capital Management. He’s bullish on Amazon as well as Apple Inc., which is largely sitting out the spending race.

Margin Compression

The oil shock that roiled markets earlier this year may continue now that the ceasefire between the US and Iran appears to be over. That was unwelcome news for stock investors, who have to look past inflation at a three-year high, rising prices for memory chips and expectations of Fed rate hikes. Profit margins are expected to shrink across S&P 500 sectors, with notable exceptions in energy and materials.

Market leadership is shifting, with cyclical sectors like semiconductors expected to benefit from the heavy capex spending by AI hyperscalers, said Savita Subramanian, head of US equity and quantitative strategy at Bank of America Corp.

Indeed, cyclicals is one of the few parts of the S&P 500 where Wall Street expects to see minimal erosion in profit margins. In contrast, growth companies are projected to post a decline in second-quarter profit margins to 30.8% from 35.4% in the January-March period. Margin compression is projected to be even more dramatic for the Magnificent Seven tech giants, down to 27.7% this quarter from 36.2% in the prior one, with many of the firms spending hundreds of billions of dollars building out AI infrastructure.

“High valuations in the mega-cap tech space are creating vulnerabilities to any signs of weaker margins or slower capex spending growth,” Brian Jacobsen, chief economic strategist at Annex Wealth Management, wrote in a note on July 6.

Europe, Asia

Investors seeking diversification from the US technology trade are finding bargains in some European and Asian stocks. In Europe, Deutsche Bank strategists expect Stoxx 600 firms to report a 12% jump in second-quarter earnings, following a 7% rise in the first quarter. Profits for MSCI Asia Pacific constituents are estimated to rise 39%, up from 6.9% in the previous three months, data compiled by Bloomberg show.

Bloomberg

Whether the trend can continue hinges on the war in the Middle East, which has upended oil markets. “US-Iran relations are key for European and Asian earnings as they’re more energy reliant than the US,” said Aneeka Gupta, director of macroeconomic research at WisdomTree UK Ltd.

The steep decline in crude prices this spring as the tensions appeared to cool is set to boost earnings for stocks in countries that are predominantly oil importers, including Japan, South Korea, India and Taiwan. The lower costs are also likely to boost margins in energy-intensive sectors, such as airlines, petrochemicals, utilities and consumer staples. But with the airstrikes continuing, those higher prices could reappear in the second half.

Rising Equity Supply

For years, Big Tech companies have been steady buyers of their own shares, helping to keep their stock prices high. But that’s changing as the firms deploy capital to support the growth of their businesses, which helps explain why Microsoft, Meta and Apple all saw their stock floats climb in the second quarter, according to data compiled by Bloomberg.

The shift has many Wall Street strategists concerned that buybacks will no longer offset new issuance. Google-parent Alphabet’s recent $85-billion stock offering was the largest in the S&P 500 in the second quarter, but it was hardly alone. Super Micro Computer Inc., Constellation Energy Corp., American Electric Power Co. and Digital Realty Trust Inc. all sold shares.

Bloomberg

“After roughly a decade of net share-count shrinkage from corporate buybacks, especially in tech, the supply picture is shifting,” said Ameriprise’s Saglimbene. Additional equity sales outside of the major indexes, including the record initial public offering for SpaceX, have also contributed to a sharp spike in equity supply.

Beyond equity issuance, traders are also concerned about the massive debt deals by hyperscalers and other tech firms and their impact on free cash flow, according to Erin Kolo, senior vice president and manager of PWM equity and fixed income research at Baird.

“What the Street wants to see is these companies showing proof points that even though they’ve made these big investments, they’re starting to bear fruit,” Kolo said. “The cash flow metrics are going to be especially important for these companies in the second quarter earnings season.”