(Bloomberg) -- To say that hopes are high heading into fourth-quarter earnings season would be an understatement.
The results about to be unleashed on the world are billed as the ones that confirm the end of the U.S. profit recession. This time around analysts have barely bothered with their ritual of cutting estimates in the weeks before companies disclose results. At 11.5, the COBE Volatility Index is at its lowest level for any earnings season since 2007.
Investor sentiment is unabashedly high, with option costs falling and money flowing into stocks at an almost unprecedented rate. Confidence is building as oil prices rebound and data on everything from manufacturing to the labor market show signs of improvement.
Yet with the S&P 500's valuations sitting near a 14-year high, the margin of safety is perilously thin. According to a study by BMO Capital Markets, once the market's price-earnings ratio tops 20, profits are about the only thing that drives equities, and investors usually endure lower returns and higher volatility.
"There is certainly a lot of optimism," said Peter Jankovskis, who helps oversee $1.6 billion as co-chief investment officer of Lisle, Illinois-based Oakbrook Investments. "There is a danger if those expectations aren't met."
Analysts forecast income at S&P 500 firms expanded 4.3% in the fourth quarter with banks, utility and technology companies experiencing the fastest growth, at least 7%. Growth will pick up to around 10% over the first three quarters of 2017, they say.
Much has been made of the unwillingness of Wall Street analysts to lower estimates heading into this week, with many framing it as evidence results will be robust. But the reluctance also leaves a higher bar to clear when companies report. The 2.3-percentage-point decrease in growth forecasts was the second smallest in data tracked by Bloomberg.
Fewer downgrades signal fewer positive earnings surprises, said Bank of America's strategist, Savita Subramanian. Fourth-quarter profits will likely end up only 1% above consensus, compared with the average beat margin of 3.5% post financial crisis, she wrote in a Jan. 8 note.
For now, equity bulls are echoing optimism among analysts. In the past two months, almost $50 billion was added to exchanged-traded and mutual funds that invest in U.S. stocks, a pace that's been surpassed only once since the dot-com era. At the same time, investors are giving up on hedges against losses.
Such bullish positioning may be risky in a market where eight years of stock rallies have pushed the S&P 500's P/E ratios to 21, a level that's near the highest since 2002 and probably leaves more price gains dependent on profit growth.
BMO divides market performance since 1955 into two categories — one in which prices are driven by changes in valuation, the other driven by earnings. It found the S&P 500 rose an average 4.2% a year in EPS-driven periods, trailing the 14% advance in P/E-driven periods.
Moreover, EPS-driven periods experienced negative returns about a third of the time, compared with 18% for valuation-driven periods, and suffered almost two times as many 105 declines.
"Earnings-driven environments tend to produce much lower and more volatile returns when compared with periods when P/E expansion was driving stock market performance," strategist Brian Belski wrote in a Jan. 13 note. "We do not believe investors fully understand the implications."
Stocks have added about $2 trillion in value since Donald Trump's election, driven by speculation that his pro-business policies will benefit corporate profits. To Russ Koesterich, co-portfolio manager of the BlackRock Global Allocation Fund, tax cuts will be the market's "best chance" of hitting profit expectations. He estimates that S&P 500 companies would add $5 to $7 a share in profit this year should corporate tax rates be lowered from 35% to 20%.
Ed Clissold, chief U.S. strategist at Venice, Florida-based Ned Davis, disagrees, saying it's too early to say tax cuts will fix the valuation problem.
"The argument that the forward P/E is not high due to the potential for tax cuts both ignores where valuations are currently and relies on events that are far from certain," he said in a Jan. 10 note. "A tax cut does not solve the long-term valuation problem unless it triggers sustained economic growth."