Don't be frightened away by the Middle East situation! Barclays sees corporate profit as the "magic wand" of American stocks, but Wall Street is sounding the alarm of a "profit bubble."

Barclays Europe stock strategist Emmanuel Kao said that investors should be prepared for further turmoil in the Middle East, but should not make significant adjustments to their investment portfolios as the key factor driving the stock market is still corporate profit growth. He said in an interview, "I think we are trying to avoid overreacting to news headlines." This week, the situation in the Middle East once again became the focus of the market. On the evening of July 8th local time, the US military launched attacks on Iran for the second consecutive day, striking Iranian infrastructure such as bridges, airports, and ports. Subsequently, Iran retaliated by striking Kuwaiti US military targets. In addition, US President Trump said at a NATO summit on July 8th that he believed the US-Iran memorandum of understanding "has ended." Trump said in response to a question from reporters that he believed the memorandum of understanding "has ended" and would inform US negotiators. Trump also said he did not want to deal with Iran. The renewed mutual attacks between the US and Iran are casting a shadow over efforts to reach a lasting peace agreement. However, Kao said that after the recent continuous rise in the stock market, a moderate return to rationality is not a bad thing. He also pointed out that the previous drop in oil prices "may have been too fast and too large." Kao said that investors should be prepared for continued market volatility throughout the summer and warned that the tense geopolitical situation in the Middle East is unlikely to disappear in the short term, but there is still a possibility of conflict cooling down, which will help prevent a continued sharp rise in oil prices. Regarding investment strategies, Kao's core recommendation is to moderately diversify from the highly concentrated technology stocks in the market and focus on industries that benefit from investment spending growth. He said that in the second half of this year, corporate profits will be the most important factor determining the direction of the stock market, and companies that can sustain profit growth will be most able to further strengthen investors' confidence in their performance. He added, "Our core allocation strategy remains clearly focused on corporate profits." After nearly all of the recent gains in the S&P 500 index have come from corporate profit growth, the upcoming second quarter earnings season will be a critical test for the US stock market. FactSet statistics show that S&P 500 component companies are expected to achieve double-digit profit growth for the seventh consecutive quarter, with analysts currently forecasting overall earnings growth of over 23%. However, in recent days, some market observers have warned that Wall Street analysts' expectations for corporate profits are being raised at an unusually rapid pace, and if costs for AI companies rise, demand for technology decreases, or spending cannot be converted into profit, profits may not meet expectations. This "profit bubble" combined with the asset bubble at the current price level in the US stock market creates a high degree of unsustainability, and once the bubble bursts, the US stocks may experience a significant correction of 30% to 50%. Currently, profit expectations for chip companies and so-called mega-cap companies are being driven by the surge in demand for AI computing power. However, Ben Inker, co-head of asset allocation at GMO, stated that profit expectations in the next two years are "rising extremely quickly, similar to what has only been seen during the recovery phase after a crisis." Market consensus forecasts predict that earnings estimates for next year will be raised by nearly 20% within six months, marking the largest increase since 2021. He added, "The market will eventually realize that these optimistic forecasts are difficult to fulfill, and this risk is accumulating. This high-growth trend has seriously deviated from the long-term logic supported by the real economy. A recent report from the UK investment bank Panmure Liberum indicated that the cyclically adjusted price-earnings ratio (Shiller CAPE) of the S&P 500 index is currently around 41 times, approaching the historical peak during the internet bubble period 25 years ago. What is particularly critical is that the earnings growth rate per share of current US listed companies has deviated from the long-term trend by 1.8 standard deviations. The institution pointed out that if corporate profit growth rates are adjusted to normal levels, the cyclically adjusted price-earnings ratio of the S&P 500 index would actually soar to 67.6 times, which would deviate from the long-term average by 4.6 standard deviations, surpassing any historical peak in US asset bubbles. Panmure Liberum's chief investment strategist Joachim Clement emphasized that the "unusual" profit windfall cannot last forever, as major tech giants shift their enormous capital expenditures from light asset operations to heavy asset models in areas such as AI data centers, the return to normal corporate profit growth is a highly probable event. However, he also acknowledged that similar market conditions have often lasted longer than expected, and profits may continue to grow rapidly in the coming years. Analysts from Capital Economics warned this week that "AI-related stock markets may be approaching a tipping point where profit expectations and assumptions about capital spending are unsustainable," and such an adjustment in these markets could "trigger a significant market correction overall." Michel Lerner, head of analysis at the UBS investment platform HOLT, also stated that the stock prices of the AI industry chain are set to maintain abnormally high profits, and warned that a "profit bubble" is forming in the market. Peter Beerenz, chief strategist at the independent macroeconomic research firm BCA Research, pointed out that this inflated profit growth is highly deceptive to investors, as similar "profit bubbles" have occurred in industries such as banks and residential builders just before the global financial crisis erupted in 2007-2008. Beerenz said that Wall Street analysts are often unable to predict the top of the "profit bubble," but historical experience shows that once industries such as semiconductors, which have typical boom-bust cycles, peak and trigger the bursting of the bubble, the US stock market may experience a sharp decline of 30% to 50%. Additionally, Andy Constant, CEO of the macroeconomic consulting firm Damped Spring Advisors, and industry experts like Jim Paulson from Wall Street have recently expressed concerns about the current overly optimistic profit expectations. They pointed out that the current pace of US macroeconomic growth is simply unable to support the aggressive corporate profit blueprints under the pens of Wall Street analysts. Christian Muller-Grisman, head of asset allocation research at Goldman Sachs, also believes that the previous earnings surprises driven by AI in the last earnings season helped the US stock market soar significantly, but this phenomenon is unlikely to be repeated this quarter, as corporate performance alone is not enough to trigger a significant rebound in the market. The question is not whether it can exceed expectations, but rather by how much and whether the market will buy into it after exceeding expectations. Although listed companies are likely to continue to exceed expectations, the baseline threshold for this earnings season has clearly been raised." Muller-Grisman pointed out that investors will focus more on the forward-looking indicators and management commentary of corporate performance to capture signals of whether the stock index can continue to climb slowly on the existing basis. He further explained that in the later stages of the cycle, the upward momentum of profit revision may continue for a long time, but this round of large-scale earnings surprises tied to AI capital spending is likely coming to an end. Overall, it is important for investors to remain cautious and vigilant in the face of potential market volatility and uncertainties, especially in the context of inflated profit expectations and asset bubbles. Monitoring geopolitical events such as tensions in the Middle East and the potential impact on oil prices will be critical in determining investment decisions and managing risks effectively.