Tech executives are racing ahead at full speed: What’s the upside for investors?

The Artificial Intelligence (AI) speed train accelerates as tech companies stoke the boiler with heaps of capital expenditure (capex) and very optimistic outlooks. Will this capex deliver high returns on capital? Is there still big upside for AI chip spending (volume/price) next year given the surge and rush to get ahead of others this year? Despite the swift speed of capex this year and stretched valuations, we believe that most trillion-cap stocks and the market overall will climb modestly higher in a year provided the titans of Tech and Communications keep delivering and guiding to 15% earnings per share (EPS) growth. DWS analysts and our tech focused portfolio managers believe that the Great Eight will deliver with exciting new AI products and enhancements. Thus, we lift our 12-month S&P target more than the usual bump up for the passage of time and normal EPS growth owing to a higher rate of EPS growth now expected for 2025 & 2026. While we expect dips around the US election, we expect such dips to be short-lived if political power is balanced after the election and an even-handed tax and spending plan emerges to restore fiscal health. We think the degree of fiscal discipline ahead will affect the degree of monetary easing.       

 

Raised 12-month S&P 500 target to 5600: 21.5x trailing $260 EPS in June 2025

Slowing inflation, vanishing recession fears and especially surging AI related capex and optimism pushed current S&P EPS yields vs. bonds yields to levels not seen since the late 1990’s. Our target 21.5 price-to-earnings (PE) ratio on trailing 4-quarter S&P EPS is above what current bond yields plus a normal equity risk premium (ERP) would support. However, we now expect 10% S&P EPS growth to be sustained into 2026. We raise our 2025E S&P EPS to $270 from $265 on 15-20% EPS growth at the Great Eight stocks and 7% from the rest; and while we do not formally estimate 2026 S&P EPS at this moment, our target assumes it is near $300.

 

Our 21.5x PE target relies on multiple years ahead of strong S&P EPS growth

At 2026 end, we expect the S&P 500 to trade at roughly 20x trailing EPS or roughly 6000, assuming no recession on the horizon at that time and that 10yr Treasury Inflation-Protected Securities (TIPS) yields are 2% or less. Forecasting well into the future is obviously uncertain, but constructive views on this market cannot be substantiated without approximating longer-term S&P EPS and being comfortable with an outlook for an above normal growth rate for a few years. Our robust S&P EPS growth outlook through 2026 underlies the 15% “growth premium” included in our trailing 21.5 PE target for June 2025, which is 3 points higher than 1 divided by long-term real interest rates plus a 350-400bp (basis point) ERP or the 18.5 average S&P PE since 1995.

 

Normal and healthy EPS growth expected in Europe, Asia stronger on a bounce

Beyond the US, EPS growth should be healthy and support respectable price gains over the next 12-months. We estimate 6% EPS growth in Europe, 9% in Japan and 13% in Emerging Markets (EM). With Europe returning to EPS growth, its record PE discount to the US should not expand. Recent snap elections in France have created political uncertainty. However, the populistic government in Italy did not prevent Italian stocks from outperforming. We also favor equities in Japan. The competitive position of Japanese companies and their exports are much improved from the weak yen and modest price increases so far. Furthermore, we think Japan is relatively well positioned if geopolitical tensions worsen.

 

Focused on the EPS outlook: Optimistic on EPS, but subpar compensation seen

Earnings growth best explains S&P 500 gains in recent years and the longer-term past. There is no need to seek new theories. High uncertainty remains on all that drives interest rates, earnings and “growth premiums” over the next year. While we see good reasons for optimistic outcomes, we think it’s important to seek compensation for uncertainty and even optimism. At current valuations, we see subpar compensation for the risks ahead even with our optimistic EPS and interest rate expectations. Furthermore, while the earnings trends support it, we are concerned by the persistent leadership momentum at the S&P 500 and now the 35% concentration from eight stocks all at valuations and aggregate market caps that suggest great expectations. Just as earnings drive stocks and the market over time, we believe portfolios could benefit from diversification. We think even optimists should consider diversification and demand better compensation for the risks and the concentration of the Great Eight.