Stocks’ strong April gains come with 1 potential downside

The stock market has been rocking in April, no doubt about it.

However, that momentum comes with an ugly downside the bulls are forgetting about: possibly unrealistic future earnings expectations that could prove to be a major headwind to further gains.

The problem: New research from Citi shows that the market is pricing in 11.7% compounded earnings growth for the next five years. This level has been matched only a handful of times over the past four decades, Citi strategist Scott Chronert wrote. In turn, the burden of proof is on fundamentals to deliver, as the current bottom-up consensus of 12.6% earnings compound annual growth “leaves little margin for error.”

Wonky, but important: Chronert’s deconstruction of the S&P 500’s (^GSPC) value shows that 41% of current levels are attributable to companies’ base earnings per share, with the remaining 59% tied to future growth, which is elevated relative to historical examples. Specifically, 39% of the index’s value is attributable to future growth in excess of 3%. That is in the 95th percentile over the past 40 years.

“Valuations are extended again after the index rally across a wide spectrum of S&P 500 constituents,” Chronert wrote. “The aggregate implied five-year EPS growth rate presents a significant hurdle. This does not mean that valuations alone provide a sell signal. Rather, it puts a burden on future growth expectations to deliver.”

April and the stock market, on rewind: The S&P 500 has experienced a dramatic run-up in April, rebounding sharply from the late-March lows as the war-risk premium evaporated following a ceasefire in the Middle East. The index has surged more than 9% this month alone, driven by a relief rally that has seen investors rotate aggressively back into growth sectors and large-cap tech names like AI chip darling Nvidia (NVDA).

The upward momentum has pushed the S&P 500’s forward price-to-earnings (PE) ratio to 22.8x, its highest level in over two years and well above its 10-year average of roughly 18x. Investors are now paying a steep premium for future earnings growth even as interest rates remain elevated and the geopolitical backdrop remains uncertain.

The bottom line: Stocks have defied conventional thinking the past few weeks. Common sense suggests that the ongoing war with Iran and still-high energy prices would be headwinds to how much investors are willing to pay for companies.

But first quarter earnings season has been impressive, and as long as that continues with Big Tech results from Amazon (AMZN), Apple (AAPL), and others in the “Magnificent Seven” group, the bulls could easily stay in control.