By Martin Baccardax

Investors are struggling with a contradiction at the heart of the market as stocks move into their toughest months of the year. On the one hand, earnings have been strong. On the other, economic data are showing signs of weakness. How the two variables play out could determine whether the stock market can keep rallying to new highs -- or stumbles into an end-of-summer selloff.

There has been nothing wrong with corporate profits. A stronger-than-expected second-quarter earnings season is on pace to lift collective S&P 500 profits by around 11.2% to $556 billion, according to data collected by LSEG. That is a $20 billion improvement from the start of the reporting period, and largely powered by gains in artificial intelligence and financials.

Around 80% of the 330 companies that have reported so far have topped Wall Street's forecasts, and the full-year earnings target has risen modestly higher to around $265 per share.

Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, also highlighted another bullish signal from the second quarter reporting season.

"Our favorite gauge of earnings sentiment for the S&P 500 -- the rate of upward EPS estimate revisions to the upside -- moved up from the mid-50% range where it had been stuck in the past few weeks to more than 61%," she said in a note published Monday. That would peg it at the highest levels in around three years, according to RBC data.

"At the same time, the percent of companies issuing positive guidance also moved up for the month of July as a number of companies (as expected) adjusted their tariff assumptions in a favorable way," Calvasina added.

The robust outlook, however, stands in contrast to the economic data and outlook. Last week's July employment report, which included a softer-than-expected headline reading of 73,000 and massive net revisions that lopped nearly 260,000 from this year's overall tally, underscored weakness in the job market that is expected to extend into the autumn months.

Consumption data from the Commerce Department's second quarter GDP report was also soft, with similar trends found in data from the Bureau of Economic Analysis.

The Institute for Supply Management's benchmark reading of activity in the services sector, the key driver of U.S. growth, slipped to 50.1 points last month. Not only is that barely above the 50-point mark that signals contraction, but the report also included data that showed the highest level of input prices in three years.

"The economy is on the precipice of recession," said Mark Zandi, chief economist at Moody's Analytics in a post on X. "That is the clear takeaway from last week's economic data dump. Consumer spending has flatlined, construction and manufacturing are contracting, and employment is set to fall."

Meanwhile, inflation might be ticking higher as a result of President Donald Trump's tariff regime, with the overall rate of levies likely to settle at around 19%, according to Samuel Tombs, chief U.S. economist at Pantheon Macroeconomics. He also notes that the president's efforts to slash government spending, and reduce the federal workforce, will also act as a drag on growth prospects.

That has markets in what the BlackRock Investment Institute strategists, led by Jean Boivin, calls a "tug of war between the economic drag of tariffs and U.S. corporate earnings strength driven by AI...The latter is winning so far, in our view, but getting granular views is key as companies and consumers each eat tariff costs."

Expect the tension between earnings and data to rise as the stock market heads into the throes of the August holiday season and the final month of the third quarter in September. Those two months, in fact, generally produce returns of around -0.7%, according to data from Truist, compared with an average gain of around 0.7% for the other months of the year.

And that suggests the markets are ripe for a modest reversal, writes Deutsche Bank strategists Parag Thatte, who notes that the S&P 500 has drops of around 3% every month and a half to two months. "It has been well over three months since the last one in April," he explains. "Somewhat larger pullbacks of 5% or more have occurred every three to four months on average."

Even then, the "path of least resistance is for the market to continue higher," says Charlie Ashley, portfolio manager at Catalyst Funds, if for no other reason than companies like Nvidia, Microsoft, and the rest of Big Tech seem to be going strong.

"Most of the large-cap companies -- the 'Magnificent Seven,' the market leaders driving the S&P 500 -- have already reported strong results," he said. "This reduces downside pressure on the market overall, and since they've already reported, they can continue to power the market higher."

Until they can't.

Write to Martin Baccardax at martin.baccardax@barrons.com

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August 05, 2025 12:19 ET (16:19 GMT)

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