In 2026, the earnings multiple will be more important than the earnings

This is an excerpt from a recently published quarterly portfolio review. I manage a model portfolio that invests in undervalued, out-of-favour predominantly large-cap companies with prospects for improvement on a 1-2 year time frame. The portfolio returned just over 24% in 2025. 

This is not a 2026 outlook piece. It’s more about how I’m thinking about the year ahead.

Everyone gives a forecast at this time of year. As is the nature of forecasts, they tend to gravitate towards a similar number.

I don’t know what that specific number is, but the pundits in both Australia and the US (and everywhere else for that matter) are all pointing to markets in 2026 being ‘higher’.

A recent Livewire survey of 5,000 investors saw about 70% of respondents expecting the market to head higher this year, while 30% think we’ll end the year lower. At least that’s more nuanced than investment bank strategists!

Still, it points to broadly bullish positioning as we start the year.

And in a sign of recency bias, the survey revealed that 36% of respondents expect resources to be the best performing sector this year. That’s well ahead of the next best sector, information technology at 17%.

Again, that tells you positioning is bullish in commodities. While momentum is certainly strong in the sector, the consensus behind these numbers should be a concern.

As a guess, I’m thinking the commodities story in 2026 could be a tale of two halves.

Getting back to the outlook for equity markets, both here and in the US.

The bullish assumption that markets will move higher typically stems from predicting a certain level of earnings growth.

It’s important to remember, however, that markets (and individual share prices) are a product of earnings AND the multiple applied to those earnings.

It’s well known that as we head into 2026, markets are broadly expensive. As of the week ending 9 January, the S&P500 forward-looking PE multiple was 22.1. This is inflated by the Mag Seven stocks, which are on a forward PE multiple of 28.1.

The S&P500’s closing price of 6,966 on 9 January is a function of the forward earnings estimates ($315) and the multiple on those estimates.

$315 x 22.1 gives 6,966.

Predicting earnings isn’t the hard part. Predicting the multiple on those earnings is.

That’s because the earnings multiple is all about sentiment. When investors are bullish and the outlook is strong, markets will trade on higher multiples. It’s only when uncertainty creeps in that multiples begin to contract.

Markets are inherently uncertain. When earnings multiples (whether for markets in general or stock-specific) are high, it indicates that investors aren’t fully pricing in this uncertainty. Rather, they’re putting a premium on certainty!

This makes me nervous. I don’t want to be buying in that environment. It might feel safe, but it’s not.

I see the bigger risk in 2026 being around the multiple, not the earnings. If the multiple on the S&P500 falls to its longer-term average of around 16 times, that would represent a decline of 27.6% from current levels.

That’s not a prediction. But it’s a reminder that multiples matter.

While optimism remains around AI-driven growth, earnings multiples will likely remain high. But if uncertainty creeps in and tempers the rosy outlook, multiples can contract quickly.

The risk for 2026

As I mentioned, nearly all the Wall Street strategists reckon markets are going higher this year. But Rajiv Jain, Chief Investment Officer and CEO of portfolio company GQG Capital Partners [ASX:GQG] thinks otherwise. Part of me thinks his concerns are too obvious. But sometimes it’s the obvious risks we overlook completely.

In a recent Barron’s Roundtable, he said:

We believe earnings growth is going to slow down meaningfully for the biggest technology companies, not to mention semiconductor companies. We see the rate of change in capex peaking in 2025.

The biggest tech stocks driving the market are the companies ramping up capex. Amazon.com’s capital spending is on track to be higher than its AWS [Amazon Web Services cloud computing] revenue. Google’s capex is much higher than its cloud revenue. The company’s cloud business margins went from 5% in 2023 to 22% last year as depreciation was extended to six years from three years. Go back four years, and the business was losing money on a net basis. We believe the true economic life of GPUs [graphics processing units] or TPUs [tensor processing units] is closer to three years.

The market for public cloud appears to be 90%-plus penetrated. The market leaders’ growth has slowed. Public cloud and advertising are two key drivers for hyperscalers, but digital advertising penetration is also reaching 75% globally. The Magnificent Seven [Alphabet, Amazon.com, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla] are mature, with slowing revenue growth and declining free cash flow. That should have a negative impact on the market—and that assumes no blowup in the bond market or anything like that.

Whether Jain turns out to be right or not remains to be seen. But at 28 times earnings for the Mag Seven, it’s fair to say investors aren’t entertaining this outcome at all.

And that’s a worry.

It’s outcomes with a reasonable probability that aren’t priced in that I worry about. That is certainly the case with the Mag Seven.

Closer to home, and you only have to look at the performance of the ASX’s ‘quality growth’ stocks over 2025 to see this. Back in the March quarter review, I said the ‘quality growth bull market is dead’.

Here’s how some of these key stocks performed over the past 12 months:

Wisetech Global [ASX:WTC] – down 46.6%
CSL Ltd [ASX:CSL] – down 38.9%
Xero [ASX:XRO] – down 36.8%
Pinnacle [ASX:PNI] – down 27.7%
ARB Corp [ASX:ARB] – down 21%
Car Group [ASX:CAR] – down 19.5%
Breville Group [ASX:BRG] – down 16.4%

I don’t know whether these downtrends will persist into 2026. But I do know that despite the share price declines, the valuations still aren’t compelling.

And you’ve got the popular ‘blue chips’ that remain expensive given their earnings growth forecasts.

Stocks like Wesfarmers [ASX:WES] trading on a forward PE of 32.5x…

Commonwealth Bank [ASX:CBA] at 24.5x…

Macquarie Bank [ASX:MQG] at 18.8x…

Or JB Hi Fi [ASX:JBH] at 20.1x.

Nothing wrong with these businesses…but there is a lot wrong with the price.

As we head into 2026, I think investors are too willing to pay a high price for comfort and certainty.

In this business, you get paid for taking on discomfort and uncertainty.

That’s why we often buy stocks that are out of favour, or just not on investors’ radars.

It’s worked so far. With discipline, I expect it to continue to work in the years ahead.

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