For most of the past year, investors have been trying to answer what seems like a fairly straightforward question: How can the stock market continue to rise when interest rates keep moving higher? The conventional answer is that interest rates simply do not matter as much as they used to. We are not sure that is right. In fact, there is growing evidence that higher rates are doing almost exactly what we would expect them to do: they are putting pressure on valuations. The basic valuation relationship is well established: higher required rates of return increase the discount rate applied to future cash flows, which, all else equal, lowers their present value.
The interesting part is what has happened next. Earnings have bailed the market out.
As expectations for interest rates have moved higher, the forward price-to-earnings multiple on the S&P 500 has moved lower. Investors are quite literally paying less for each dollar of expected earnings than they were several months ago. FactSet reported that the S&P 500’s forward 12-month P/E ratio stood at 19.2x on September 25, down from 20.4x at the end of the second quarter. Ordinarily, that would be a problem for stock prices, but earnings expectations have been moving rapidly in the other direction.
See more: Stock Market Tug of War: Earnings vs. Rates
There are only so many ways for a stock to increase in value. The company can earn more money, investors can decide to pay more for those earnings, or some combination of the two. This year, investors have been getting substantially more of the former and less of the latter.
Since June 30, the S&P 500’s forward 12-month EPS estimate has risen 8.9%, while the price of the index has increased only 2.7%. Over the same period, the forward P/E multiple has fallen from 20.4x to 19.2x.
That distinction matters because it helps explain what has otherwise looked like a contradiction. Higher rates have not been irrelevant to the equity market. They have shown up through lower valuation multiples. The reason stock prices have continued to rise is that earnings growth has been strong enough to more than offset the pressure from lower valuation multiples. FactSet currently estimates third-quarter S&P 500 earnings growth at 29.1% year over year, up from an estimate of 26.7% at the start of the quarter. If realized, that would mark a third consecutive quarter of earnings growth above 25% and an eighth consecutive quarter of double-digit earnings growth.
In that sense, the market has benefited from what we might call an earnings cushion. As long as earnings continue to grow faster than valuation multiples contract, stock prices can still move higher. If earnings rise 15% while the multiple investors are willing to pay falls 5%, the market can still produce a positive return. That is effectively the tug-of-war playing out today.
Here is where the story gets more complicated. Even after this period of multiple compression, the market is not particularly cheap. The S&P 500 trades near 19x forward earnings, while the Nasdaq 100 and Russell 2000 trade at approximately 23x and 24x, respectively. Several major benchmarks remain above their 20-year median valuations.
That does not mean the market is destined to fall. Historical valuation averages are not hard ceilings, and valuation is not a particularly reliable short-term timing tool. What it does mean is that the margin for error may be smaller than the headline strength in the market would suggest.
If interest rates decline and earnings continue to grow, we think the market could once again benefit from two positive forces at the same time: stronger earnings and some degree of multiple expansion. If rates remain elevated but earnings growth stays strong, the current environment can persist. The more difficult outcome would be one in which rates remain high while earnings growth begins to slow. In that scenario, the cushion starts to disappear.
For now, the earnings backdrop remains strong. FactSet projects S&P 500 earnings growth of 29.1% for the third quarter and 26.8% for the fourth quarter, with full-year 2026 earnings growth estimated at 32.0%. Analysts currently expect earnings growth to moderate to 15.4% in 2027. The current strength therefore provides a cushion, but it also raises the importance of what happens to earnings growth from here.
That is why we think the earnings story matters so much. The market has already absorbed some of the impact of higher rates through lower valuation multiples. So far, corporate earnings have been strong enough to offset it. The question is whether that remains true if growth becomes more difficult to sustain.
Higher rates have already taken something away from valuations. Earnings have given it back. The question is whether they can keep doing it.
Source: FactSet Earnings Insight, September 25, 2026.
Authored by Keith Buchanan
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