First-Quarter Earnings Driving Stocks to Record Highs

In recent weeks, major equity indexes have hit record highs, which may seem at odds with geopolitical fears and the performance of other asset classes. Energy prices remain elevated due to the stalemate in the Strait of Hormuz amid the Iran conflict. Many soft commodity prices have risen on fears that transport and fertilizer will add to costs. The 10-year Treasury yields are also up, about 40 basis points, since the start of the year.

Interestingly, a solid rebound once the initial uncertainties of a geopolitical shocks are known is normal. 

But, as we highlight today, the first-quarter (Q1) earnings season has provided fundamental support for the rally in equities.

Equity prices and earnings move together in the long run

Remember that, in the long run, nothing matters more to equity performance than earnings. That’s due to the simple fact that when you buy a share of stock, you’re buying a sliver of that company’s future stream of earnings. The chart below shows that going back decades, equity prices (blue line) and earnings (green line) move together. In essence, we are looking below at prices and earnings – and the stability between the two is one reason why the prices-to-earnings (PE) ratio is such a common and simple valuation tool.

Careful watchers will note that there are times when stocks (or earnings) get ahead (or behind). These are often explained by interest rates (grey area). For example:

• In the ‘70s and early ‘80s, prices fell behind the rate of earnings growth (effectively, PE ratios fell). Interestingly, that was also when interest rates were pushed high as then-Fed Chair Paul Volcker tried to tame energy-driven inflation. As any stock valuation model will tell you, higher interest rates reduce valuations as they add more interest expense, which reduces companies' net earnings.
• We also see that markets tend to look past recessions (grey bars), which cause earnings to fall, but only temporarily. 

Most importantly, these dislocations are resolved over time. 

Chart 1: Rising earnings supporting rising equity prices

Earnings supporting this year’s rally

Spoiler alert: Q1 earnings were good — surprisingly good.

Based on what we talked about above, we can mathematically decompose stock returns into two drivers:

• Growth in earnings: In the case below, we are using forward earnings. Given stocks reflect future earnings that should be better than historic or actual earnings.
• Expansion in multiples: If a stock’s PE ratio goes up with no change to earnings, that’s called “multiple expansion” – because the stock price ends up (mathematically) being a “multiple” of earnings. 

The data shows that forward earnings have grown for all market caps and subgroups in the chart below (green bars). Importantly, for large caps, earnings are growing faster than prices, resulting in falling PE ratios (multiples).

Even for the smaller stocks in the S&P 400 and S&P 600, earnings growth accounts for well over half of the positive returns.

Chart 2: Large-cap earnings outpacing price gains, compressing PEs

Q1 earnings show improved breadth

Much has been written recently about the concentration in stocks driving S&P 500 returns.

But looking at earnings, we see a broadening of companies that are profitable.

For example, S&P 500 earnings growth was positive across 10 out of 11 sectors. Only Health Care saw earnings fall. 

Smaller companies also saw earnings improve, with the S&P 400 mid caps growing earnings 14% p.a. and the S&P 600 small caps delivering 6% p.a. earnings growth — its fourth straight quarter of positive earnings growth (Chart 2 and 4).

Chart 3: 10 out of 11 large-cap sectors saw earnings gains

Why are more companies suddenly more profitable? 

As we highlighted after Q4 2025 earnings, the deceleration in inflation and wage growth from their 2022 highs not only slowed operational cost growth, but also enabled the Fed to cut rates, reducing interest expense. That has especially benefitted small caps since they rely more on floating rate debt than mid- and large-cap companies. 

These factors, combined with an increase contribution from high-margin AI chip sales, helped drive margin expansion.

Magnitude of large-cap gains exceeded market expectations, driven by AI

The size of the earnings gains surprised most experts. 

Although a lot of the larger gains were made by so-called hyperscalers, benefiting from AI revenues. In fact, in Chart 4, we show the proportion of revenue growth from these companies.

Chart 4: Q1 earnings strength is supported by more than just AI and big tech

Overall, the:

• Nasdaq-100® Index saw 46% per annum (p.a.) earnings growth. That’s typically seen only when recovering from a recession, but this is the 12th straight quarter of 15% p.a. or higher earnings growth. Of course, the Nasdaq-100® is home to four AI hyperscalers – AMZN, GOOG, META, and MSFT – which contributed more than half of all earnings growth in the Nasdaq-100®.
• S&P 500 saw the group (which includes a fifth hyperscaler: ORCL) contribute more than a third of the S&P 500’s 28% p.a. earnings growth.

Even after capex spending, AI hyperscalers remain in good financial health

There was some concern that hyperscalers were spending too much on AI-related capex. To be fair, the numbers are incredible – Morgan Stanley estimates that the five companies spent $450 billion on capex last year, but that will rise to $800 billion this year and hit $1.1 trillion next year.

However, these are also some of the most profitable companies in history. In fact, they funded a lot of their capex out of free cash flow (although, they have relied on debt financing more recently). 

Even still, the data below suggests that their financial health remains solid.

To measure the health of the AI hyperscalers, but also the rest of the Nasdaq-100® and S&P 500, we use a lease-adjusted net debt-to-equity metric. This shows how leveraged a company really is once you account for net debt, and we include long-term lease obligations since a 15-year data center lease (for example) is essentially the same as a fixed interest rate cost on a bond (it’s something you are committed to pay, regardless of demand).

This measure shows that the AI hyperscalers (dark blue line) have lower net debt to ratios than the rest of the S&P 500 orange line) and are in line with the rest of the Nasdaq-100® (light blue line).

Chart 5: AI capex spending spree leaves hyperscaler finances as good or better than other large caps

And this is even with large-cap net debt-to-equity ratios falling over the last few years as these companies have improved their financial wellbeing.

Strong earnings and multiple contraction push back on bubble concerns

In recent weeks, the relationship between equity prices and earnings has reasserted itself, pushing the major equity indexes to record highs amid a historic earnings season in both magnitude and breadth. 

Despite concerns about an equity bubble, PE multiples have actually compressed for large caps this year – including the AI hyperscalers. If we see earnings continue to grow, it may well justify further equity price gains.