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(Bloomberg) — The US stock market’s strongest two-year rally since the dot-com bubble is heading into its next big test as companies start releasing quarterly earnings, providing a major gut check on whether valuations have outrun the underlying reality. 

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On Friday, the S&P 500 Index slid 1.5% — its worst drop since mid-December — as an unexpected surge in hiring solidified speculation that the Federal Reserve won’t cut interest rates again until the second half of the year. 

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But the bigger issue is the high bar set by investors’ estimates: The reports are expected to show that the resilient economy increased the earnings of the companies in the S&P 500 by 7.3% during the fourth quarter from a year earlier, according to data compiled by Bloomberg Intelligence. That’s the second-highest pre-season forecast in the past three years, and it threatens to put equities on a shaky footing if the results — or the outlook for the months ahead — fall short. 

With the S&P 500 priced for roughly 23% earnings-per-share growth in the next 12 months, the estimates embedded in stock prices are unusually high, BI data show. Bottom-up consensus forecasts — a method of forecasting future stock performance by adding up individual analyst estimates for each of the S&P 500 companies — are calling for 13% EPS growth in 2025, meaning those projections would need to nearly double to justify where the S&P 500 trades.

“We haven’t seen a hurdle this high since 2018,” said Michael Casper, senior equity strategist at BI. “It’s going to be a lot harder for companies to continue to beat profit estimates this year than in 2024 because the bar was much lower then.”

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Fourth-quarter earnings season will officially kick off on Wednesday, led by financial bellwethers JPMorgan Chase & Co., Citigroup Inc. and BlackRock Inc. More key companies will deliver results the following week, including, Netflix Inc., Procter & Gamble Co. and 3M Co.

Here’s a look at five key themes to watch as the results roll in:

Broadening Growth  

One closely-watched issue is whether the earnings-growth momentum will accelerate beyond the largest tech companies, which could provide a boost to some of the market’s laggards. 

With the economy performing well, companies outside of big tech are expected to report a third straight quarter of earnings growth, with profits estimated to rise 4% and accelerate toward double-digit increases by the first three months of 2025, according to data compiled by BI. 

Tech companies will still be a key market driver. But investors are prepared for the so-called Magnificent Seven companies — Nvidia Corp., Apple Inc., Microsoft Corp., Alphabet Inc., Amazon.com Inc., Meta Platforms Inc. and Tesla Inc. — to report a slowdown in growth: Profits are expected to rise by 22%, compared with average earnings growth of 34% in 2024, when the rest of the S&P 500 rose 4.5%, according to BI.

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Trade, Tariffs & Taxes 

Investors are also looking for insight into how President-elect Donald Trump’s tax-cut, tariff and deregulatory policies will trickle through Corporate America. While some of his plans threaten to upend global trade and fan inflation pressures, the stock market has been focused more on the upside of a pro-growth agenda. 

Yet the type of tax cuts being eyed in Washington may only reduce the tax burden on the S&P 500 by about half as much as the 2017 package, according to BI’s Casper. He said that adds another hurdle to meeting the steep EPS growth baked into the S&P 500 over the next 12 months. 

The dollar’s recent surge is another open question: While that may take the sting off the impact of a tariff increase by cheapening import costs, it could also darken the outlook for multinational companies by reducing export demand and the value of overseas earnings. 

Profit Revisions

Traders are watching a key indicator known as earnings-revision momentum, a gauge of upward-to-downward changes to expected per-share earnings over the next 12 months for the S&P 500. It has been hovering in negative territory, BI data show, indicating that Wall Street analysts are trimming their estimates heading into earnings season. 

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While that isn’t unusual, it could be an early sign of shifting sentiment. The tech sector’s 12-month forward EPS revision momentum, for example, has dropped for 11 of the last 12 weeks, driven by markdowns for high-flying semiconductors companies.

Three of 11 sectors in the S&P 500 are poised to have seen profit growth accelerate by double digits in the final three months of 2024, including communication services and technology, along with previously unloved groups like health care. Energy is forecast to post a roughly 30% profit contraction from a year earlier in the fourth quarter, BI data show. 

Monitoring Margins

Traders will keep a close eye on operating margins after inflation came down from the post-pandemic surge, easing some cost pressures. Analysts see operating margins for the fourth quarter at nearly 16%, with the worst of the pain in the rear-view mirror as forecasts improve in the coming quarters, data compiled by BI show.

Europe’s Earnings Tide

Expectations for European earnings are far more subdued as the continent contends with stunted economic growth at home and in China, an important trading partner for its luxury-goods and car companies. The prospect of US tariffs is a worry for its export-heavy industries in 2025.

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Profits for the Stoxx 600 are projected to have risen just 3% in 2024, compared with 8% for the S&P 500, and will likely trail again this year, BI data show. The focus will be on automakers like Volkswagen AG that are facing threats from protectionist policies, tepid demand in China and the loss of US tax credits for some plug-in cars. Luxury firms including LVMH and Gucci-parent Kering SA will be bellwethers of consumer spending patterns.

“The big picture for European equities is that the growth environment remains very challenging,” said Lilian Chovin, head of asset allocation at Coutts.

—With assistance from Sagarika Jaisinghani and Michael Msika.

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