The S&P 500 Is Expecting Something Extraordinary. History Says Investors Should Be Careful What They Wish For.

If you pay attention to current Wall Street expectations, you'd have good reason to feel bullish.

LSEG is currently forecasting S&P 500 (SNPINDEX: ^GSPC) earnings growth of 31% year over year in the third quarter. Of course, this is heavily driven by growth in the tech and semiconductor spaces, but energy could also make a big contribution.

This would sound like a great time to buy stocks with that kind of fundamental strength existing in the background. Plus, the forward price-to-earnings (P/E) ratio for the S&P 500 has actually dropped slightly to 21. In other words, the recent rally has been driven largely by earnings growth, not multiple expansion. That's also a good sign for a sustainable rise in stock prices.

But the real question is how much of this good news is already priced in? If the market already expects 31% earnings growth, there may not be much of a reaction when it actually happens. An earnings beat could cause a stock's price to pop.

But what happens when expected earnings growth is already so strong that the more likely surprise is to the downside?

It wouldn't necessarily be a stock market crash. But it could be the trigger for a 10% correction that the S&P 500 hasn't seen in a year and a half.

Image source: Getty Images.

The potential problem with earnings booms

While earnings growth of 31% sounds extraordinary (and it is), the circumstances surrounding that growth will influence how stocks might perform going forward. For example:

• 2021: Corporate earnings growth surged following the pandemic shutdown, which was a generational anomaly. That growth was also fueled in part by trillions of dollars of Fed stimulus. That worked until inflation rates soared and led to the 2022 bear market.
• 2010: Earnings growth grew at triple-digit rates after the economy finally bottomed post-financial crisis. Stock prices were able to keep rising, but a lot of it was clawing back losses from a historic bear market and recession.
• 2004: Earnings growth rates exceeded 70% early in the year as the economy recovered from the tech bubble bursting. This was a case where stocks continued advancing higher over the subsequent year.
• 2000: Year-over-year earnings growth again topped 30% as the internet boom picked up speed. Shortly thereafter, however, the tech bubble burst, and stock prices crashed.

In 2026, we have an artificial intelligence (AI) fueled earnings boom. Growth is being fueled by enormous capital investment, and it's inevitable that these rates will eventually slow. But only time will tell whether this economy slows to a sustainable long-term growth rate or crashes, as it did in 2000.

There's another complication. Roughly two-thirds of earnings growth is expected to come from AI-adjacent tech companies. Earnings growth is not broad, which makes it especially vulnerable to a reversal if capital expenditure (capex) spending slows or there's a regulatory push to slow the development of AI. Plus, the extra earnings growth coming from the energy sector is being helped by surging oil prices. That's the result of a geopolitical event that could reverse quickly if there's a resolution to the Iran war.

In short, a 31% earnings growth rate sounds incredible. But if it's already priced into stocks and being driven by just a handful of companies, there's a high risk that it could end with a market correction.

Here's what I'd do with my money

A 31% earnings growth rate with a forward P/E ratio of 21 is a pretty good risk/reward trade-off at the moment. The risk is that the AI spending cycle starts to peak and/or contract. That could send both earnings expectations and valuations for the S&P 500 lower.

I'd focus on three practical moves:

1. Maintain your core portfolio positions in funds like the Vanguard S&P 500 ETF (NYSEMKT: VOO) or the Vanguard Total Stock Market ETF (NYSEMKT: VTI). Trying to guess when the cycle might slow is difficult, if not impossible. Better to stay exposed and treat this as short-term noise.
2. Review your overall tech sector exposure. You're already getting plenty through these two ETFs. If you own a tech, semiconductor, or growth ETF, your allocation to the sector could easily be 40% to 50% of your portfolio. Consider trimming if you're overweight.
3. Keep investing. Maintain systematic investing plans and 401(k) contributions.

Own a diversified portfolio and avoid the temptation to bet that current earnings growth rates will continue indefinitely.

David Dierking has positions in Vanguard Morningstar Total Stock Market ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.