U.S. stocks hit new all-time highs this week, but the foundation supporting this rally is under scrutiny. The current surge in corporate earnings expectations is almost entirely driven by two one-time tailwinds: the explosion in AI chip demand and the Iran conflict—both of which are clearly temporary and could reverse at any moment.
This week, the S&P 500 reached a new peak, rising approximately 3% from its high last October. Concurrently, the index's forward price-to-earnings (P/E) ratio has dropped significantly from over 23 times to briefly fall below 20 times, currently sitting around 22 times. This combination of a sharp decline in the P/E ratio occurring alongside rising stock prices has no precedent in historical data going back to 1985—every previous instance of such a substantial valuation drop was accompanied by falling stock prices.
This superficial "improvement in valuation" has comforted investors, but a warning suggests the current "cheapness" may be an illusion. The AI data center construction boom has driven a sharp increase in chip prices, while the Iran conflict has boosted oil prices and energy company profits, collectively lifting earnings expectations and depressing the P/E ratio. Should the AI boom reverse or tensions in the Gulf ease, what appears today as reasonable low valuation might, in hindsight, look expensive.
The S&P 500's forward P/E ratio is currently about 22 times. Although down from its peak last October, it remains well above the long-term average of 16 times. There is a clear divergence of opinion between bulls and bears regarding the sustainability of the current valuation level.
**Unprecedented: Record Highs Coincide with Valuation Compression**
The basic logic of the forward P/E ratio is to divide the stock price by Wall Street analysts' forecast for earnings per share over the next 12 months. When earnings expectations are revised sharply upwards while stock prices rise relatively modestly, the P/E ratio naturally declines.
Historically, significant upward revisions to earnings expectations typically buoyed shareholder sentiment, causing stock prices to rise even more, thereby pushing valuations higher, not lower. A sharp drop in the P/E ratio almost always signaled bad news in the past—often because an economic recession caused earnings expectations to fall faster than stock prices.
This time, two main factors are driving the surge in earnings expectations: first, the explosion in AI demand has led to a sharp rise in chip prices; second, the Iran conflict has significantly boosted energy company profits. The market views both as temporary factors. This combination has created an unprecedented divergence between valuation and stock prices.
**AI Chips: Cyclical Concerns Lurk Behind Profit Surge**
The change in valuation within the AI sector is most typical in memory chip manufacturer C3.ai, Inc.. The company produces high-speed memory chips essential for AI, and its sales surge has far exceeded market expectations, enabling significant price increases and margin expansion.
In October of last year, the median analyst forecast for C3.ai, Inc.'s 2027 earnings per share was $19; now, that forecast has risen to $101. However, while expected earnings have increased nearly fivefold, its stock price has only roughly doubled, leading to a substantial decline in its P/E ratio.
It is noted that a lower valuation does not necessarily mean the stock is cheap; rather, it reflects the market's expectation that the current supernormal profits are temporary. The memory chip industry has historically been highly cyclical; as more production capacity comes online, prices will eventually fall. Data center demand is also expected to slow once the initial surge is satisfied.
Optimists argue that AI stocks are transitioning from speculative trading to genuine profit realization. Scott Chronert, U.S. equity strategist at Citigroup, pointed out that measured by the price/earnings-to-growth (PEG) ratio, the valuation of the eight largest tech and AI stocks at the start of the week was at its lowest level since 2013.
Pessimists contend that growth expectations remain too high, data center expansion forecasts exceed reality, large tech companies have shifted from a capital-light to a capital-intensive model, Wall Street earnings forecasts are inherently prone to significant error, and the risk of the Iran conflict reigniting is being overly ignored by equity investors. These multiple factors pose a downside threat.
**Oil Stocks: War Premium Fades, Valuation Compression Unsustainable**
The distortion of oil sector valuations by the Iran conflict is also significant. Oil prices soared due to successive restrictions on Persian Gulf oil exports by Iran and the U.S. The expected profits for the next 12 months for the three major oil giants are about one-third higher than at the end of February, and the oil sector's forward P/E ratio has dropped from 23.8 times pre-conflict to 15.6 times.
However, upon news of a ceasefire, oil stock prices fell sharply, retracing their gains back to pre-war levels, even though earnings expectations continued to rise. News of the Strait of Hormuz reopening further pressured oil prices on Friday—although Iran again claimed the strait was closed on Saturday, by which time markets were closed.
The oil futures market had already signaled that prices would eventually fall. For shareholders, while the temporary boost to profits is beneficial, the market truly focuses on profits that grow sustainably year after year. The speed at which the war premium has dissipated clearly shows the structural limitations of this benefit.
**Two Major Themes Priced In, Low Valuation Carries Reversal Risk**
The current pricing of both AI and oil stocks is based on the market's most optimistic expectations for two core themes: the data center construction boom and the Iran conflict. This makes the overall market appear cheaper on paper.
But the fragility of this "low valuation" is evident: if the AI boom turns to bust, or a peace agreement is reached in the Gulf, today's apparent bargain might look expensive in retrospect. For investors, the current forward P/E ratio, based on the next 12 months, fails to fully reflect the risk of an earnings slowdown that could arrive a year from now, offering very limited buy or sell signals.
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