By Jack Hough
Parents of teenagers demanding driving lessons will quickly reacquaint themselves with what some car manufacturers call the passenger-side assist grip. The more popular name has three words starting with "oh" and ending with "handle," with an s-word in the middle that shan't be employed here. Stock investors could use an OSH right about now. Up 8%, down 5%, down 4%, up 6% -- these are just a handful of the single-day herk-a-jerks since the beginning of February for shares of America's largest company, Nvidia. The broader S&P 500 index this past week had briefly slid 9% from its January high, then rocketed back several points, and was last seen trying to decide on its next adventure.
Blame the crude oil spike and related speculation about how long the U.S. will be at war with Iran, of course, along with on-again, off-again angst about whether big companies are spending unwise or unsustainable sums on artificial intelligence. Here we suggest a third factor: The U.S. stock market is significantly more expensive than it appears.
The reasons have to do with how accountants treat all that AI spending, plus signs that some longer-term trends that have flattered corporate profitability and economic growth might be overstretched. Let's run through three factors. Don't worry: This isn't a call to flee stocks. It's a suggestion to beware of buy-the-dip-itis. That's a condition that can lead novice and even experienced investors, who have been treated to rapturous returns over the past decade and who haven't seen a bear market that took longer than a year to recover since October 2007 to March 2009, to now pile on risk whenever the market hiccups.
If anything, now is a better time to recalibrate expectations, and bolster resilience. More on that ahead.
Follow the Cash
The earnings trend for big U.S. companies has been sublime. Consensus expectations for the S&P 500 have been steadily ratcheted higher. The latest calls for 17% earnings growth this year. To tell whether stocks in general are cheap, many investors look to the market's price/earnings ratio. If the price has come down a little, and the earnings are going up a lot, the market starts to look reasonably priced. Based on projected earnings for the year ahead, the S&P 500's P/E is 20, which, in a mathematical coincidence, is about 20% higher than the 20-year average -- a premium, but not an excessive one.
Now consider a different measure, free cash flow. The index's forward P/FCF ratio of 27.4 is 37% above its 20-year average. Suddenly the premium doesn't seem as moderate.
Earnings and free cash flow are two ways of measuring the same thing: the money companies make after expenses. The difference between them normally doesn't matter much for the market as a whole. But AI spending has made the current difference exceptionally wide: S&P companies are expected to earn $2.8 trillion this year but generate only $1.9 trillion in free cash.
The main difference between those figures has to do with the treatment of spending on big-ticket items like data centers and equipment, called capital expenditures, or capex. Earnings accounting doesn't subtract capex when the money is actually spent. Instead, it deducts it little by little over the projected useful life of the stuff being bought. There's nothing scandalous about that. It's called the matching principle. Accountants try to match big, lumpy investments with the yearslong income they produce by pretending the spending is stretched out.
Free cash flow doesn't pretend anything. In fact, it's not an accounting measure. Companies aren't required to report it on financial tables, although many volunteer it on news releases and slide decks. To calculate it yourself, start with a financial report line item called cash from operations, and then fully subtract capex.
We apologize for bringing arithmetic into this--we'll try not to let it happen again. But the difference between earnings and free cash flow matters a lot now, for two reasons. First, we've never seen so many companies spend this much, this suddenly. Look at Amazon.com. Two years ago, nine analysts had ventured estimates of the free cash flow Amazon would generate by 2026. They ranged from $76 billion to $126 billion, with an average of $105 billion--a staggering haul reached only by two companies, ever: Apple and Saudi Arabia's oil monopoly. Today, the 2026 consensus estimate for Amazon stands at $11 billion--of cash burn, not free cash flow.
Of course, Amazon hasn't fallen on hard times. It has gone all-in on building AI computing power as quickly as possible. That might well pay off. Amazon has a long history of successful investing, and of profitably renting out the computing heft that it builds. But Alphabet, Microsoft, Meta Platforms, and others are spending lavishly, too. Meta, whose capex is estimated at $122 billion this year, or five times what it was spending five years ago, doesn't sell cloud computing. We'll be interested to see how these investments do, but for our purposes here, it's simply the scale and speed of the ramp-up that matters.
That brings us to the second reason that the difference between free cash flow and earnings is particularly important now: Although earnings don't subtract right away for all of this AI spending, they do fully add the money that flows to companies on the receiving end of the spending. For now, by mostly telling only the happy part of the story, earnings are left puffed up.
Nvidia, the AI chip king, will likely turn the biggest corporate profit in history in its fiscal year ending next January. The estimate stands at $200 billion. Until three years ago, the company had never earned more than $10 billion in a year. Other data-center arms dealers whose earnings have suddenly multiplied include memory maker Micron Technology, expected to make $66 billion this year, the fifth largest contribution to the S&P 500's total, and chip designer Broadcom, $56 billion and ninth largest.
The sustainability of this spending matters a great deal for deciding whether stocks are expensive. But at the very least, investors should make sure the spending is counted when they're sizing up the market. On an index level, free cash flow does the fairest job of that now, and it says that prices are high.
Let's go through two more factors that have blessedly little to do with AI, and have been many years in the making.
Marvelous Margins
In general, corporations are much more profitable than they used to be. Across the economy, their cumulative profit margin has recently been around 12%, even before the AI binge. For the four decades through 2000, it averaged 5.3% and topped 7% only once -- around when the dot-com stock bubble peaked.
On its own, this isn't a bad thing. Since the 1980s the economy has grown less weighted in heavy industry, and more weighted in technology, which has brought structurally higher margins. Our profitability surge might be long-lasting, or even permanent. But some signs should give investors pause.
One of these signs is that the earnings split between workers and corporations has shifted a lot lately -- corporations are getting a much bigger share of the gross-domestic-income pie, and workers, a meaningfully smaller one. We leave it to others to opine on whether the current split is optimal. Our focus here is investor returns. We note only that workers, of course, are also customers. If they're struggling to keep up with costs, we'd expect to see consumer spending suffer. It hasn't. But some economists see evidence of a so-called k-shaped economy, where the two legs of the k represent different income groups, with a relatively small slice of high earners boosting spending growth. Others note that credit card debt for low earners has been rising.
Here's why this matters for corporate earnings: If it's true that the rich are propping up the economy, earnings might be benefiting from a strong wealth effect. That's the tendency of consumers to spend more when their stocks and home values are riding high. The S&P 500 index, even with its recent wobbles, has returned a stupendous 273% over the past decade, or more than 14% a year. A normal return for stocks over long time periods is closer to 10% a year before inflation. The Case-Shiller index of U.S. home prices is up 87% in a decade, or about 6.5% a year. The best estimate of a normal return there is the rate of inflation, which was 3.3% a year over the past decade.
Whatever level of profit margin is normal for companies now, if the current one is benefiting from a wealth effect, it's boosting earnings and holding down P/E ratios. The problem is that the wealth effect works in reverse, too. Big price drops for the overall housing market are rare, but not unheard of. Ones for stocks are fairly common.
Government Assistance
You won't be surprised to learn that the federal government will spend much more than it collects in taxes this year. It did so for much of the four decades to 2000, averaging deficits of 2% of GDP a year. But this year's shortfall is estimated at 5.8%, rising to 6.7% in a decade. That's emergency-level spending, only without the emergency, and with no end in sight. These deficits have accumulated into a monstrous debt. We've been hearing dire warnings about it for years, with little impact on interest rates or investor returns, so why worry now?
There are many reasons, but let's focus on two. Social Security's trust fund is expected to run dry in 2032, so either benefits will have to be cut by then, or taxes raised. Meanwhile, the U.S. in recent years has been borrowing at interest rates that exceed the nominal economic growth rate. Starting after 2031, without momentous changes, the interest rate on the entire debt will exceed the growth rate permanently, and increasingly. That's what economists refer to as a debt spiral. It's like a saver borrowing at 5% to fund a 3% certificate of deposit--the numbers don't work.
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April 03, 2026 13:07 ET (17:07 GMT)
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