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Investing.com -- Solid earnings growth during Q2 is “insufficient” to sustain the stock market rally and a recession later this year, BCA Research noted in a Tuesday report.

Earnings and sales growth have broadened across sectors, but BCA cautions that much of the market's recent gains are driven more by price-to-earnings (P/E) multiple expansion rather than actual earnings performance. This reliance on valuation multiples, combined with looming economic uncertainties, suggests the rally may not be sustainable in the long term.

In Q2, the S&P 500 reported year-over-year earnings growth of 12.7%, an improvement from the 8.2% growth in Q1. Sales growth also accelerated, reaching 5.4%, up from 3.9%. However, BCA points out that despite these robust results, the market’s reliance on P/E multiple expansion rather than earnings growth presents a risk.

Since October 2023, earnings in the S&P 500 have increased by only 6.3%, while forward P/E multiples have surged by 19.8%. This suggests investor sentiment, rather than company fundamentals, has driven the recent rally.

One of the key issues raised in the report is the potential slowdown in earnings growth from the "Magnificent Four" group, which includes tech giants Nvidia (NASDAQ:NVDA), Microsoft (NASDAQ:MSFT), Alphabet (NASDAQ:GOOGL), and Amazon (NASDAQ:AMZN).

These companies had powered much of the market's gains, with their collective earnings growing by a staggering 130% in Q1 2024. Yet, BCA cautions that growth may cool significantly, with estimates showing it could slow to 28% by the end of the year.

In contrast, earnings growth for the remaining 496 companies in the S&P 500 is expected to rebound from a decline of -1.2% in Q1 to 16% by year-end. While this broadening of earnings is positive, it may not be enough to sustain the overall market rally if the "Magnificent Four" see their growth taper off significantly.

Sector rotation is also underway, with healthcare and financials showing accelerating earnings growth, while technology, consumer discretionary, and communication sectors are slowing.

“As a result, earnings growth rates across sectors are leveling off, and there are fewer extreme readings. However, this process is still running its course and can easily be derailed,” BCA notes.

Another concern mentioned by BCA strategists is the delayed monetization of generative AI (GAI). Despite significant investments in GAI by major tech firms, tangible returns have been slow to materialize. They expect it will take longer than most investors anticipate for GAI investments to produce meaningful income, adding to the uncertainty over future earnings growth for these companies.

Overall, the firm believes investors should consider defensive positioning “as solid earnings growth is insufficient to rule out a recession later this year.”

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