Forget Tariffs! Earnings Quality Is a Far More Sinister Worry for Wall Street.

Key Points

• Despite double-digit gains for the S&P 500, Dow Jones Industrial Average, and Nasdaq Composite in 2025, headwinds are mounting for the stock market.

• President Trump’s tariff and trade policy has caused heightened volatility on Wall Street and modestly increased the U.S. inflation rate.

• However, corporate earnings quality is of the utmost importance amid a historically expensive stock market.

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The third year of Wall Street’s bull market rally didn’t disappoint. When the curtain closed last year, the S&P 500 (SNPINDEX: ^GSPC) had risen 16%, marking its third consecutive year of gains totaling at least 16%. Meanwhile, the Dow Jones Industrial Average (DJINDICES: ^DJI) and Nasdaq Composite (NASDAQINDEX: ^IXIC) both rallied by double digits and leaped to several record-closing highs.

Though catalysts have been bountiful for stocks — looking at you, artificial intelligence (AI) — this historically pricey market is also rife with potential red flags. Stock market corrections are the price of admission to the greatest wealth creator on the planet, and several headwinds are mounting that threaten to pull the rug out from beneath Wall Street.

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A lot of attention is currently being paid to President Donald Trump’s tariff and trade policy and its effect on corporate America. While historic stock market volatility stemming from Trump’s tariff unveiling in early April underscores the uncertainty surrounding this issue, there’s a far more sinister worry for Wall Street and investors: earnings quality.

President Trump conducting an interview. Image source: Official White House Photo by Joyce N. Boghosian.

Trump’s tariffs are having a modest inflationary impact

In the two days following the reveal of the president’s tariff and trade policy on April 2, the benchmark S&P 500 lost 10.5% of its value. This marked its fifth-steepest two-day decline since 1950.

Initially, Trump introduced a 10% global tariff rate, as well as higher “reciprocal tariffs” on dozens of countries that were deemed to have adverse trade imbalances with the U.S.

Since introducing this tariff and trade policy over 10 months ago, several changes have been made to the original reciprocal tariff rates due to dealmaking and/or implementation pauses. However, the threat of President Trump imposing new or higher tariffs on select countries has persisted since April 2025.

Aside from the uncertainty about when tariffs may be implemented, there’s concern about how these import taxes can impact American businesses and jobs. For this, I’ll turn to an analysis (“Do Import Tariffs Protect U.S. Firms?”) from four New York Federal Reserve economists, writing for Liberty Street Economics.

According to the contributing authors, Trump’s China tariffs in 2018-2019 had a lasting impact on public companies long after their initial implementation. U.S. companies affected by these tariffs, on average, saw their labor productivity, employment, sales, and profits decline from 2019 to 2021. That’s clearly not good news for corporate earnings if history were to repeat with the latest round of Trump tariffs.

Additionally, the inflation rate has moved modestly higher since the president’s tariffs began affecting the U.S. economy. Input tariffs (duties placed on imported goods used to complete the manufacture of a product domestically) have increased production costs for select businesses, leading to higher prices for consumers. A higher inflation rate makes it less likely that the Federal Reserve will lower interest rates.

While Donald Trump’s tariffs have certainly made waves on Wall Street, they’re of far less concern to the stock market than earnings quality.

Image source: Getty Images.

Wall Street has an undeniable earnings quality issue

To preface the following discussion, valuing stocks and the broader market is a subjective task. There isn’t a one-size-fits-all blueprint that investors use to evaluate businesses or major stock indexes, meaning there’s always going to be some degree of unpredictability to short-term stock movements.

Nonetheless, we entered 2026 with the second-priciest stock market in history, according to data from the S&P 500’s Shiller Price-to-Earnings (P/E) Ratio, also known as the Cyclically Adjusted P/E Ratio (CAPE Ratio). This valuation tool, which has averaged 17.34 when back-tested over 155 years, has been vacillating between 39 and 41 for months. Only the dot-com era was pricier than the rise of AI.

Earnings quality is paramount to maintaining this valuation premium. By “earnings quality,” I simply mean that fast-growing businesses are generating their profits from their operations and not relying on less desirable means to effectively “pad their stats.” While some market leaders are absolutely delivering for their shareholders, others are clear examples of Wall Street’s earnings-quality issue in action.

For instance, “Magnificent Seven” member Tesla (NASDAQ: TSLA) is trading at an estimated 202 times forecast earnings per share (EPS) in 2026. For a triple-digit forward P/E, we’d expect jaw-dropping growth and the company’s operations to be doing the heavy lifting. What investors are actually getting is projected sales growth of less than 9% this year and a significant reliance on unsustainable income sources.

These unsustainable income sources consist of automotive regulatory credits the company receives for free from governments around the world and net interest income earned on its cash. In 2025, Tesla generated $1.99 billion from regulatory credits and approximately $1.34 billion in interest income (after interest expenses). These unsustained and non-innovative income sources accounted for a whopping 63% of its pre-tax income!

But Tesla isn’t the only Magnificent Seven stock whose earnings quality should be called into question. While Apple (NASDAQ: AAPL) is still generating boatloads of operating cash flow, it’s been relying on a share buyback smoke-and-mirrors show to obfuscate its lack of real earnings growth.

Since initiating its share repurchase program in 2013, Apple has bought back $841 billion of its common stock and lowered its outstanding share count by more than 44%. Buybacks of this magnitude have had a decisively positive impact on its EPS.

In Apple’s fiscal 2022 (Sept. 24, 2022), it generated $99.8 billion in net income and produced $6.15 in full-year EPS. By fiscal 2025 (ended Sept. 27, 2025), it generated $112 billion in net income and $7.49 in EPS. Net income only rose 12.2% over three years, but EPS jumped nearly 22%. Apple has been masking subpar sales and profit growth with its market-leading share-repurchase program.

To be clear, what Tesla and Apple are doing is perfectly legal and smart from a business standpoint. But amid a historically pricey stock market, this isn’t what you, as an investor, should want to see from market leaders. Wall Street’s influential businesses should lead with innovation, not share buybacks, interest income, automotive regulatory credits, and other non-innovative sources of revenue/income.

Wall Street has an earnings quality problem, and it may come back to bite investors.

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Sean Williams has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple and Tesla. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.