Audrey Deschenes
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Why earnings expectations explain everything about the stock-market rally

If you want an explanation for why the U.S. stock market has rallied 15% this year in the face of geopolitical uncertainty and rising interest rates, all can be explained by earnings outlooks, according to Nick Colas, co-founder of DataTrek, a market research firm.

Colas isn’t even talking about trailing earnings, which have been rather stellar so far this year, with third-quarter earnings growing nearly 6%, according to FactSet.

The S&P 500 SPX, -0.38%  is trading at 18 times next-year’s earnings. Put a different way, investors expect earnings to grow by 11% and are willing to pay a multiple of 18 times for those profits today.

Colas, who doesn’t think a forward price to earnings ratio of 18 is particularly cheap, is skeptical of earnings estimates. Analysts have a record of being too optimistic when it comes to forecasts.

But what if analyst estimates are too low instead of too high? Colas set out to get a clear picture of estimates by looking at the best- and worst-case scenarios for the 20 largest companies in the S&P 500, which includes megacap tech companies and represent almost a third of the index.

Crunching some numbers, Colas found that even under the worst-case scenario, where every one of these 20 companies hits the most pessimistic earnings estimate, “this cluster of dominant stocks only trades at a forward price-to-earnings valuation of 20.3.”