Investors returned to the stock market with renewed enthusiasm over the past week, with tech stocks leading the charge. This momentum followed U.S. President Donald Trump’s recent diplomatic endeavors in Iran, which initially appeared to pave the way for a fragile peace. However, by the end of the week, tensions resurfaced as Iran hinted at the possibility of re-closing the Strait of Hormuz, and negotiations met delays, sparking renewed frustration from the President on social media. Despite these geopolitical developments, traders largely remained unfazed by the turmoil in the Middle East, focusing instead on the burgeoning impact of artificial intelligence on the economy.
The latest figures reveal a significant upswing in corporate earnings, with the S&P 500 index reporting nearly 30% profit growth in the last quarter. This statistic is a key indicator that many investors cite to rationalize the stock market’s relentless ascent. However, a closer examination of these earnings figures uncovers a more complex reality.
A substantial part of this impressive growth can be attributed not directly to core business operations of major tech companies, but rather to their investments in one another. According to finance professor Baolian Wang from the University of Florida, nearly half of the reported profit growth in the S&P 500 can be traced to this peculiar earnings distortion—a phenomenon that raises concerns over the sustainability of these numbers. If the earnings narrative falters, it could pose substantial risks for investors.
For instance, consider Alphabet Inc., which reported approximately $25 billion in net income mainly from its core operations, including advertising and subscriptions. Yet, buried deeper within its financial statements is a line labeled “other income (expense).” Historically a minor entry, Alphabet’s “other income” soared to an astounding $38 billion last quarter—accounting for 60% of the company’s bottom line and dwarfing the annual profits of some industry-leading firms, including Canada’s Royal Bank.
Alphabet stands as a significant investor in Anthropic, the developer behind the Claude family of AI models, which is poised for its own massive IPO later this year. This interdependence among major tech players fuels an ongoing cycle of inflated earnings. Both Amazon and Nvidia also reported extraordinary earnings boosts from their investments in AI ventures, with paper gains contributing significantly to their profitability.
This interconnectedness fosters a feedback loop where massive investments in startups like Anthropic and OpenAI elevate their valuations. As these private firms grow, public companies mark up their ownership stakes accordingly, leading to artificially inflated earnings reported in quarterly results. This dynamic creates an illusion that the rally in tech stocks is fundamentally supported by robust profits.
However, caution is warranted. The inflating profits based on one-time investment gains transform earnings growth rates, distorting reality. Without these extraordinary figures, earnings growth for the S&P 500 would have plummeted from 29% to a more modest 16%. Such discrepancies create a significant blind spot for investors who may not fully grasp the potential risks associated with relying on these inflated earnings figures.
The implications extend beyond U.S. borders, given the extensive exposure that Canadian investors have to American equities, estimated at $2.6 trillion last year. With U.S. stocks representing around two-thirds of the global market value, the well-being of Canadian portfolios is closely tied to the health of the American stock market.
As with any feedback loop, the situation possess the potential for reversal. If tech valuations experience a downturn—whether due to economic shifts or global events—the ramifications could echo throughout the market, turning temporary gains into losses and prompting a negative ripple effect across economies. With so much at stake, investors must remain vigilant and educated about the underlying dynamics that drive stock performance.
