As we enter the second half of 2025, markets are sending mixed signals. While equity valuations remain elevated, some of the underlying economic data is beginning to soften. This divergence raises an important question: Are current earnings expectations aligned with economic reality?
The chart below presents May 2025 leading and coincident economic indicators vs. S&P 500 forward earnings estimates. What is a bit alarming is that leading economic indicators are dropping sharply, and yet earnings estimates remain elevated. There could be (at least) two explanations for this:
- It could be that the leading economic indicators have fallen off because of the “tariff scare” that reversed itself in April 2025 and the leading indicators will turn around—this could mean that analyst expectations may still be reasonable.
- It could be that analysts are slow to adjust their earnings estimates set before the recent tariff announcements.
There is a behavioral finance bias at work in this scenario—conservatism bias. This is not an investor being too conservative! Conservatism bias is a belief-perseverance bias in which people maintain their forecasts by inadequately incorporating new information that arises.
Academic studies have demonstrated that conservatism causes market participants to overweight initial beliefs about outcomes and underreact to new information. In other words, people often fail to modify their beliefs and actions to the extent rationally justified by the new information. As a result of conservatism bias, analysts may underreact to or fail to act on new information and continue to maintain beliefs close to those based on previous estimates and information.
What Does This Mean for Investors?
The implications of analysts being subject to conservatism bias is that investors may be relying on earnings estimates that are too high. As of May 28, 2025, the forward price of earnings ratio on the S&P 500 was approximately 21x, which is well above its 20-year average of about 17x. However, if the earnings numbers are too high, then the PE ratio is artificially low. For example, if earnings estimates of $275 on the S&P 500 are even 5% too high, then the forward PE ratio is actually 22.5x.
Strategic Investment Considerations
- If consumers think inflation is on the rise, they may reduce overall spending
- They may increase their savings rate as a protective measure
- They often prioritize purchasing goods they believe are increasing in price, like durable goods over services
Investment Consequences:
The jury is still out on whether earnings estimates are too high. However, the higher-than-normal level of concentration in the S&P 500 means that future earnings—whether above or below current expectations—could have an outsized impact on market valuations.
Key Takeaway: We believe that investors should be aware of conservatism bias in action and be vigilant when relying on forward earnings estimates.
If you’d like to discuss how these insights relate to your specific financial situation and investment strategy, please contact your Sunpointe advisor. We welcome the opportunity to explain how we are helping investors navigate these challenging market conditions.
