INSIGHTS

On September 02, 2025

AAM Viewpoints — Equity Markets: 3 Reasons to be Cautious & 3 Reasons to be Optimistic

Cautiously Optimistic

“Cautiously Optimistic” — those two words are good descriptors for the equity market right now. There are so many crosscurrents in the world with some providing reasons for being cautious and others for being optimistic about equity markets. On the cautious side, market multiples are elevated, tariff impacts throughout corporate America are still uncertain, and company margins are expected to expand from already high levels. On the optimistic side, the most recent earnings season was strong and that is expected to continue through 2026, the Artificial Intelligence (AI) theme is expanding across the world, and with the passing of the “One Big Beautiful Bill,” the U.S. government continues its fiscal support throughout the economy.

Reasons to be Cautious

1. Elevated Multiples
   

   The current forward P/E (price-to-earnings) multiple for the S&P 500 is approaching 23, placing it in the top quintile of historical forward P/E ratios dating back to 1990. The chart below highlights what has happened in the past during different forward P/E multiple regimes. The blue bars show market performance when multiples are elevated (in the top quintile). As the chart shows, when multiples become elevated, like they are now, the subsequent 12-months return tends to be lower, and volatility tends to be higher.

   This chart compares starting forward P/E multiple and the subsequent market performance (returns and volatility):

   

   Source: FACTSET | Past performance is not indicative of future results.

2. Tariffs
   

   This past earnings season did not shed much light on the impact of tariffs. Most companies mentioned that they did not broadly pass on the cost of tariffs to consumers, except selectively on certain products. The consensus thinking is that so far one-third of the tariffs are being felt by exporters, one-third by importers, and one-third by consumers. But these are rough estimates, and we will have to wait until the next few quarters to gain a better understanding of their impact. One thing that was mentioned by many companies was that the goods sold this quarter came from pre-tariff inventory which did not reflect potentially higher prices from tariffs. As the higher-priced, post-tariff goods flow through the company’s income statements, they could be a headwind to companies’ margins.

3. Margins
   

   And this leads to the final point of caution — margins. As the chart below shows, margins for companies in the S&P 500 during the most recent quarter (green point) were the second highest ever. And the analyst community’s forecasts (red line) expect expanding margins through 2026. This supports some of the strong expected earnings growth in 2026. So, the key question is what would happen if margins didn’t expand and stayed flat at the current level? Capping next year’s expected margins to be at the current quarter’s level (green dotted line in the chart) results in the 2026 earnings falling by over 6%, bringing 2026 earnings growth closer to 7% from the current 13.5% expected by analysts.
   

   

   Source: FACTSET | Past performance is not indicative of future results.

Reasons to be Optimistic

1. Earnings
   

   First up on the optimism list is S&P 500 earnings. This past quarter’s earnings season was one of the stronger in recent memory. 80% of the S&P 500 companies beat their earnings estimates, 80% beat their sales estimates and 60% beat both earnings and sales estimates. All these beat ratios are 10 to 20 percentage points higher than long-term averages. As you can see from the chart below, the recent earnings season (bright blue bar) posted a 12% earnings growth which is continuing the earnings renaissance that started in late 2024. And analysts expect this trend to continue through 2026 (green bars in the chart).

   

   Source: FACTSET | Past performance is not indicative of future results. EPS = earnings per share

   This places earnings growth for 2025 and 2026 at 1.5 to 2.0 times the long-term S&P 500 average earnings growth rate of 7.0%.

   

   Source: FACTSET | Past performance is not indicative of future results.

2. Artificial Intelligence (AI)
   

   Second, expectations for AI continue to be constructive. During this past earnings season, expectations for capital expenditures among the large tech companies focused on AI — also known as hyperscalers — were confirmed and in some cases increased. Currently there are commitments of $2.5 trillion in capital expenditures for the build-out of AI throughout the world. The pie chart shows that roughly $1 trillion of that comes from governments like the United States, the European Union and countries in the Middle East (Saudi Arabia, UAE,…). The rest is committed mainly by the large technology (hyperscalers) companies in the private sector. These capital expenditures could have broad impacts across many types of companies throughout the economy. This is just one of many trends (reshoring, defense, digital currencies) occurring which could lead to increased economic activity.

3. Government Support
   

   Finally, the “One Big Beautiful Bill” passed with the expectations for continued fiscal support across corporate America. With taxes remaining low for companies and regulation easing, there could be a tailwind for earnings growth over the next few years.

Implications

Overall, the cross currents described above support the 3Ds approach to investing we have been highlighting this year: Diversification, Dividends, and Deliberate.

1. The cautious side supports diversification into defensive and income strategies. Some products are built to provide market protection, while some dividend strategies seek to provide protection through income.
2. The optimistic side leads to being deliberate and investing in some of the long-term secular trends that are emerging like artificial intelligence, reshoring, defense and digital currencies.