The relationship between earnings revisions and market performance has long been a topic of interest for investors and analysts alike. While some may assume that upward revisions in earnings estimates lead to higher stock prices, the reality is more complex. According to UBS strategist Andrew Garthwaite, there are signs that the current tight fit between earnings revisions and market performance may be coming to an end.

Garthwaite points out that earnings have been upgraded since April, with the average expectation for Q2 2023 earnings being $48.75, up from $46.50 in April. However, he notes that this upgrade cycle is different from previous cycles, as it has not led to a corresponding increase in stock prices. In fact, the S&P 500 has underperformed relative to its historical average during this period.

So why is this happening? Garthwaite suggests that there are several factors at play. Firstly, he notes that the current earnings upgrade cycle is largely driven by the technology sector, which has seen a significant increase in expectations due to the ongoing digital transformation of businesses. However, this sector accounts for only 20% of the S&P 500, leaving the remaining 80% underweight and underperforming.

Secondly, Garthwaite highlights that the recent upgrade cycle has been driven by a narrow set of stocks, with the majority of the market failing to keep pace. This is evident in the fact that only 10% of S&P 500 stocks have seen their earnings estimates upgraded since April, while the remaining 90% have seen little to no upgrades.

Finally, Garthwaite notes that the current market valuation is at an historical high, with the S&P 500 trading at a price-to-earnings ratio of 23x, compared to its historical average of around 16x. This suggests that the market may be overvalued, which could limit any potential upside from earnings upgrades.

While there has been a tight fit between earnings revisions and market performance in recent months, there are signs that this relationship may be coming to an end. The current upgrade cycle is largely driven by the technology sector, with the majority of the market failing to keep pace. Additionally, the current market valuation is at an historical high, which could limit any potential upside from earnings upgrades. As such, investors may want to exercise caution and consider diversifying their portfolios to mitigate any potential risks.