Investors should prepare for further turbulence in the Middle East, but they should not make major portfolio adjustments because of it, as corporate profit growth remains the key driver for stock markets.

Barclays' Head of European Equity Strategy, Emmanuel Cau, stated that the primary focus should be on corporate earnings. "I think we are trying to avoid overreacting to headlines," he said in an interview. This week, the Middle East has again become a focal point for markets, with recent escalations casting a shadow over peace efforts.

However, Cau noted that a moderate return to rationality after the recent market rally is not a bad thing. He also pointed out that the previous drop in oil prices "may have been too fast and too deep."

He advised investors to brace for continued market volatility throughout the summer, warning that Middle East tensions are unlikely to disappear in the short term, though the possibility of de-escalation exists, which could help prevent a sustained, sharp rise in oil prices.

For investment strategy, Cau's core advice is to moderately diversify away from the highly concentrated tech sector and focus on industries benefiting from increased investment spending. He emphasized that corporate earnings will be the most critical factor determining stock market direction in the second half of the year. Companies that can consistently deliver profit growth will be best positioned to bolster investor confidence in their performance.

"Our core positioning strategy remains very clearly centered around corporate earnings," he added.

The upcoming second-quarter earnings season will be a crucial test for US stocks, following a period where nearly all the gains in the S&P 500 over the past year have been driven by profit growth. According to FactSet, S&P 500 companies are on track for a seventh consecutive quarter of double-digit profit growth, with analysts currently forecasting overall earnings growth exceeding 23%.

However, market participants have recently warned that Wall Street analysts' earnings expectations are being raised at an unusually rapid pace. If AI companies face rising costs, declining technology demand, or struggle to convert spending into profits, earnings may fall short of expectations.

This potential "earnings bubble," combined with existing price-level asset bubbles in the US stock market, creates a "double bubble" structure that is highly unsustainable. A bursting of these bubbles could trigger a severe market correction of 30% to 50%.

Currently, earnings expectations for chip companies and so-called hyperscalers are being driven by a surge in demand for AI computing power. But Ben Inker, Co-Head of Asset Allocation at GMO, noted that profit forecasts for the next two years are "being raised at an extremely fast pace, similar only to what we've seen in recovery phases after crises."

Consensus market expectations have seen next year's corporate profit forecasts revised upward by nearly 20% in just six months, the largest increase since 2021.

"The market will eventually realize that these optimistic forecasts are very difficult to achieve, and this risk is building," Inker added. "This high-growth trend has significantly deviated from the long-term logic supported by the real economy."

British investment bank Panmure Liberum pointed out in a recent report that the Shiller Cyclically Adjusted Price-to-Earnings Ratio (CAPE) for the S&P 500 is currently around 41, nearing the historical peak seen 25 years ago during the dot-com bubble.

Critically, the current earnings per share growth rate for US-listed companies has deviated from its long-term trend by 1.8 standard deviations. The firm noted that if corporate profit growth were adjusted to normal levels, the S&P 500's Shiller CAPE would effectively balloon to 67.6 times. This figure would deviate from the long-term average by 4.6 standard deviations, completely surpassing any previous peak in US asset bubble history.

Panmure Liberum's Chief Investment Strategist, Joachim Klement, emphasized that "extraordinary" profit windfalls cannot last forever. As major tech giants shift from asset-light operations to capital-intensive models with massive spending on areas like AI data centers, a normalization of corporate profit growth is highly likely.

However, he acknowledged that such market conditions can often persist longer than expected, and profits may continue to grow rapidly for several more years.

Analysts at Capital Economics warned this week that "AI-related stock markets may be approaching a tipping point where earnings expectations and capital expenditure assumptions become unsustainable," and a correction in such markets could "trigger a broader market sell-off."

Michelle Lerner, Head of the UBS investment analysis platform HOLT, similarly stated that "AI supply chain stock prices are set to maintain extraordinary profits," warning of a forming "earnings bubble."

Peter Berezin, Chief Strategist at independent macroeconomic research firm BCA Research, noted that this inflated profit growth is highly deceptive for investors, drawing parallels to similar "earnings bubbles" seen in the banking and homebuilding sectors just before the 2007-2008 global financial crisis.

Berezin stated that Wall Street analysts typically find it extremely difficult to predict the peak of an "earnings bubble," but historical experience suggests that once a bubble bursts, often triggered by peaks in cyclical boom-bust industries like semiconductors, the broader US stock market could fall by as much as 30% to 50%.

Other industry figures, including Andy Constan, CEO of macroeconomic advisory firm Damped Spring Advisors, and veteran Wall Street investment expert Jim Paulsen, have also recently expressed concern about the current overly optimistic profit expectations. They pointed out that the current pace of US macroeconomic growth simply cannot support the aggressive corporate profit projections outlined by Wall Street analysts.

Christian Mueller-Glissmann, Head of Asset Allocation Research at Goldman Sachs, also believes that the wave of AI-driven earnings surprises that boosted stocks last quarter is unlikely to be repeated this season. Earnings alone may not be enough to spark another significant market rally.

The issue is not whether companies will beat expectations, but by "how much" they beat them and whether the market will "reward" those beats. While companies will likely continue to exceed expectations, "the bar for this earnings season has clearly been raised."

Mueller-Glissmann noted that investors will pay more attention to corporate forward guidance and management commentary for signals on whether the market can continue its slow climb from current levels.

He further explained that while upward earnings revisions typically persist for an extended period in the later stages of a cycle, "this large wave of earnings surprises tied to AI capital expenditure has most likely peaked."