Sky-high valuations face reality check amid third year of profit falls
ASX companies face a high-stakes earnings season as market valuations hit dangerous levels, with analysts warning there's no room for disappointment.
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Get ready for a volatile earnings reporting season amid stretched valuations and weak earnings growth.
Though remaining well-supported in recent days, the ASX 200 trades on dangerously high price-to-earnings multiples after three years of flat to negative earnings growth.
There’s no room for disappointment when companies start reporting next week.
With the market PE multiple rising to 19.4 times, Morgan Stanley’s Chris Nicol warns that the ASX 200 is trading more than two standard deviations above its long-term average of 14.8.
Despite a lack of aggregate earnings growth, the ASX has returned 13 per cent per annum over the past three years. In the past 12 months, its market valuation is up about 14 per cent.
This “disconnect between market earnings growth and market performance” means the market is “fully priced to say the least,” according to Wilsons Advisory’s David Cassidy.
Based on Macquarie’s earnings forecast, the ASX now trades on an even more expensive PE of 20x.
“This set-up makes for a volatile reporting season where misses will be punished,” said Macquarie’s Australian equity strategist, Matthew Brooks.
Given uncertainty about tariffs and the surprise Reserve Bank pause in July, he’s expecting another round of conservative guidance from Australia Inc.
Earnings Drought Set to Continue
The numbers paint a sobering picture. Australian corporate earnings are forecast to fall 3 per cent in 2025 after being downgraded into negative territory for a third consecutive year.
Even the expected recovery in 2026 looks anaemic, with growth estimates of 2-6 per cent.
Resources companies have been the main culprit. Their earnings are expected to drop 18 per cent this year after being hammered by falling commodity prices. This has masked better performance from industrial companies, where earnings are expected to grow around 6 per cent.
Banks – the market darlings of 2024 and 2025 – face their own headwinds. As interest rates hit net interest margins, bank earnings are forecast to fall about 3 per cent in 2026.
Signs of Rotation Emerging
All three strategists have detected early signs that investors are starting to rotate away from banks and other recent winners toward previously unloved sectors.
The clearest signal came in July, when resources stocks surged 11 per cent while banks fell 6 per cent.
Materials outperformed financials by about 10 per cent since the start of July, reminiscent of last year’s brief China stimulus rally.
But the big rotation isn’t from banks to resources – it’s from banks to healthcare.
“We think the big rotation that should occur is not Banks to Resources, but Banks to Health,” said Macquarie’s Mr Brooks. Healthcare is his top overweight position.
Five Key Themes to Watch
Morgan Stanley’s Nicol sees five key themes that could drive the market in reporting season.
First is whether Australia’s domestic economic cycle is finally showing signs of improvement. With the RBA expected to keep cutting rates and government spending continuing, expectations are high – perhaps too high.
Second is the durability of recent rotation signals, particularly whether commodity prices can sustain their strength and whether China’s property support measures gain traction.
Third is the persistence of wage growth, which continues to pressure company margins despite poor productivity growth.
Fourth is capital allocation – companies are set to outline merger and acquisition plans and whether they’re focusing on organic or inorganic growth.
Finally, artificial intelligence adoption is broadening rapidly, but investors want concrete evidence that AI investments are delivering returns rather than just adding costs.
What to Buy and Avoid
Based on the three reports, several clear investment themes emerge for the results season ahead.
Sectors and stocks to favour include healthcare companies, particularly those with positive earnings momentum like CSL, ResMed and Ramsay Health Care.
Telecommunications stocks, led by Telstra, are attracting attention after recent price hikes. Macquarie likes growth and quality cyclicals on any sell-offs, based on its expectations for domestic activity over 2026.
Specific stock picks include Challenger, Hub24, Pinnacle, Metcash, Telstra, Ramsay, ResMed, Sonic, Qantas, Sandfire and Woodside. Among smaller companies: Australian Finance Group, Spark, McMillan Shakespeare, Monadelphous, Perenti, Ventia and Amplitude Energy.
Sectors to avoid include banks after their strong run, particularly given the prospect of falling interest rates. As well as real estate players and discretionary retailers face ongoing cost-of-living pressures as energy companies grapple with falling commodity prices.
And stocks to steer clear of including Treasury Wine Estates, REA Group, Reece, and among smaller stocks, Domino’s Pizza, G8 Education, Audinate and Healius.
With valuations stretched and earnings growth still elusive, this reporting season will test investors’ nerves. The smart money appears to be rotating toward sectors and stocks with genuine earnings momentum, while avoiding recent winners that may have run too far, too fast.
Originally published as Sky-high valuations face reality check amid third year of profit falls
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