My sainted mother has always imposed infuriatingly high standards on me. For example, many years ago, when I was starting out as a daily newspaperman, I proudly informed her that I had won a local civic award for excellence in journalism. Her response: “That’s nice, dear. Maybe one day you’ll win a Pulitzer.” (Gee, thanks for the boost, mom.)

Likewise on Wall Street, good isn’t always good enough.

The stock market is a strange place where even the most outstanding corporate performances can lead to disappointing investor reactions.

This paradox, whereby solid quarterly results are sometimes met with a declining share price, often leaves investors scratching their heads.

During the second-quarter 2024 earnings season to date, the market is rewarding positive earnings surprises reported by S&P 500 companies at average levels but punishing negative earnings surprises more than average. The sustained bull market rally has upped the ante.

Companies that have reported positive earnings surprises for Q2 2024 have seen an average price increase of +1.0% two days before the earnings release through two days after the earnings release, according to FactSet. This percentage increase is equal to the five-year average price increase of +1.0% during this same window for companies reporting positive earnings surprises.

However, companies that have reported negative earnings surprises for Q2 2024 have seen an average price decrease of -3.8% two days before the earnings release through two days afterwards. This percentage decrease is much larger than the five-year average price decrease of -2.3% during this same timeframe for companies reporting negative earnings surprises.

At the heart of this dynamic are lofty expectations and sky-high valuations, especially in sectors with substantial hype, such as artificial intelligence (AI).

The AI frenzy: boom or bust?

The recent AI boom has provided a textbook example of how elevated market sentiment can turn into a double-edged sword. We’ve seen this played out during Q2 earnings season.

Artificial intelligence has been the poster child of market excitement, with tech companies touting AI as the next major driver of growth and innovation. Companies at the forefront of this revolution have seen their valuations soar as investors clamor to get a piece of the AI pie.

For many, the AI frenzy is reminiscent of past technology booms, such as the dot-com bubble in the late 1990s. Analysts and investors alike have poured into AI-related stocks, pushing prices to unprecedented levels based on future potential rather than current fundamentals.

However, with sky-high valuations comes increased scrutiny.

Take a look at the following chart, which depicts the S&P 500’s price-to-earnings ratio based on average inflation-adjusted earnings from the previous 10 years.

Known as the Cyclically Adjusted PE Ratio (CAPE Ratio), this metric shows that the stock market trades at historically elevated valuations:

As companies report Q2 2024 earnings, the pressure to meet and exceed not only their own projections but also the market’s high expectations has become overwhelming.

The perverse nature of expectations…

When a company is priced for perfection, any hint of imperfection can lead to a sell-off.

In the AI space, analysts have started to question whether the current bonanza is sustainable. Can companies consistently deliver the groundbreaking advancements and financial results that justify their inflated stock prices? As doubts grow, even strong profits and revenue figures are being punished.

This reaction is driven by a classic case of “buy the rumor, sell the news.” Investors often rush into a stock in anticipation of positive developments, driving up the price.

When the actual news arrives, no matter how positive, it is already “priced in.” The lack of an upside surprise becomes a disappointment, triggering profit-taking and a subsequent drop in the stock price.

That’s exactly what happened when chipmaking giant Nvidia (NSDQ: NVDA) and customer management software maker Salesforce (NYSE: CRM) released their quarterly operating results after the market closed Wednesday.

Nvidia and Salesforce revealed strong profit and revenue gains and handily beat consensus estimates on the top and bottom lines. However, the immediate response of investors was negative and both stocks tumbled.

NVDA and CRM ended the trading session Thursday with declines of -6.38% and -0.73%, respectively. (I’ll have more to say about NVDA, CRM, and the “earnings paradox” in my Mind Over Markets column for Friday.)

The main U.S. stock market indices closed mixed Thursday. The Dow Jones Industrial Average rose to a new record, but NVDA’s bad day weighed on the S&P 500 and tech-centric NASDAQ. The final tally:

• DJIA: +0.59%
• S&P 500: -0.00%
• NASDAQ: -0.23%
• Russell 2000: +0.66%

Economic data released Thursday bolstered the overall bull argument. Weekly jobless claims fell from the previous week. What’s more, Q2 U.S. gross domestic product (GDP) was revised higher to 3% growth from the preliminary 2.8%. Recession fears have dramatically waned.

The role of consolidation in market health…

In the context of the AI boom, a period of consolidation is beneficial. Rapid run-ups in stock prices can lead to bubbles, and a market correction helps deflate these bubbles before they reach dangerous levels. By shaking out some of the froth, the market can recalibrate and allow valuations to align more closely with fundamental realities.

As an investor, you should embrace this consolidation phase, not as a sign of failure but as a necessary step for sustainable growth. Market history has shown time and again that sectors undergoing rapid innovation often experience volatility.

The initial euphoria is tempered by a phase of consolidation, where weaker players are weeded out, and more robust, sustainable growth models emerge.

This process helps ensure that the companies that do succeed are those with genuine staying power and not just those riding the wave of hype. You don’t need a Pulitzer Prize to figure that out.

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John Persinos is the editorial director of Investing Daily.

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