Much was made of the S&P 500 Index entering “correction” territory a week ago, closing more than 10% lower than its July peak. What followed was a bounce that has erased half of that drawdown.
This volatility owes more to uncertainty about rates and bond markets than fundamentals—the U.S. 10-year yield has gone from 3.5% to 5% back to 4.5% over this period. But over the long term, earnings are what matter. Halfway through third-quarter earnings season, with some of the largest and most important U.S. companies having already reported, we have been looking at what the fundamentals are telling us about the strength of U.S. large caps.
Let’s focus on the “Magnificent Seven” stocks that have dominated index performance this year: Microsoft, Nvidia, Apple, Amazon, Meta, Tesla and Alphabet. They make up more than a quarter of the S&P 500’s market capitalization, so their strength and valuation matter a lot for the fate of the index over the coming months.
These seven stocks raced ahead of the broad market in the first half of 2023 and now trade at 27 times forward earnings, on average, even after a double-digit correction since August. The rest of the index is at 16 times.
That said, these are among the world’s most impressive companies by any measure, with growth records that can sustain high valuations. Six of the seven have reported their third-quarter results, with Nvidia due on November 21—so, how are they faring?
Positive to Mixed
We do think Tesla faces some pressures. At 53 times forward earnings, we see a full valuation that compensates little for the growing risks of consumer affordability and competition from China. It missed its third-quarter sales and earnings estimates, margins have already contracted meaningfully, and the company is talking a lot about lowering prices.
The messages have ranged from positive to mixed for the other six, however, and we think that mitigates some of the concerns we hear about substantial overvaluation.
Despite its stock price soaring by more than 200% this year, Nvidia’s artificial intelligence-oriented earnings growth has kept its multiple in line with the Magnificent Seven’s average, which we consider to be a reasonable reflection of the upside and the risks.
Meta was this year’s other big winner, up 160% so far. The market did not like management’s uncertainty about advertiser spend, but it beat its third-quarter estimates and the company’s valuation appears reasonable to us if it can deliver on growth and cost-cutting. Microsoft’s multiple also appears reasonable, in our view, especially after it met earnings expectations and showed a recovery in its cloud business.
At 20 times earnings, we do not regard Alphabet as obviously overvalued, either. The market punished it for missing estimates on cloud revenue and margins, and appears increasingly concerned about limits to the firm’s cost-cutting efforts—but we are less skeptical about that cost-cutting, and continue to see growth potential in search and YouTube.
Amazon and Apple look more fully valued, at 41 and 27 times earnings, respectively. The former is facing the same cloud-computing challenges as Alphabet, but improved its guidance on this issue. We also see its investment pipeline as a source of future growth, particularly in advertising. And while investors did not like the fact that Apple’s revenues have fallen for four quarters in a row, with no sign of a turnaround for the rest of the year, the company beat estimates for revenue and earnings, reported strong results in its (high-margin) services business, and revealed that the iPhone segment was growing again.
In short, the issue is not that U.S. technology companies have been bid up to stratospherically unsustainable valuations that are about to see the fundamentals crumble beneath them.
The issue is that their valuations are likely now reasonable-to-full, and that, at almost 30% of the S&P 500 Index, they are structurally over-owned and are unlikely to benefit from continued positive momentum. They certainly could outperform again in 2024, but it is very difficult to see them leading the index to the extent they have this year. There are likely other names below them that are at less risk of multiple compression—especially while the outlook for rates remains uncertain.
Care is warranted, however. Superficially, S&P 500 earnings appear resilient. Estimates for calendar-year 2023 have settled around $220 per share, which would represent modest growth over 2022. With just over half of the companies having reported third-quarter results, the index is on track to post the first quarter of year-over-year earnings growth for 12 months.
But we see some fragility beneath the surface. Margins have contracted for the seventh consecutive quarter. The percentage of companies beating sales estimates is at its lowest level since 2015 and both sales and earnings guidance is deteriorating. Unsurprisingly, given concerns about full valuations, the punishment the market inflicts for missing estimates is getting harsher.
That is why we think investors should be looking for large caps that can match the “Magnificent Seven” on quality, but at more attractive valuations. The concentration of liquidity into mega-cap tech names has left many examples available, in our view.
Long-Suffering Small Caps
In addition, we are asking ourselves whether it’s time to look again at long-suffering small caps. The S&P 500 Index may have briefly gone into correction a week ago, but you are still in the green if you bought in June this year. By contrast, the Russell 2000 Index peaked two years ago and is down almost a third—as low as it was in November 2020, when news first broke of a successful COVID-19 vaccine.
Our 10 Solving for 2024 themes are due out this week, and one of them will be “Laggards Find (Relative) Favor.” We think “markets with a greater degree of pessimism priced in [such as small caps] are likely to perform better than those priced for perfection, should growth disappoint or the cost of capital continue to rise.”
We think this is a theme to monitor right now, as small caps are not typically the place to be when the economy is decelerating—but they are priced very pessimistically and that may provide a buffer.
For example, to reach the (very similar) median drawdowns that each market segment suffered during the recessions since 1990, we calculate that the S&P 500 technology sector would need to fall more than twice as far from current prices as the Russell 2000. Furthermore, over 40% of the Russell 2000’s companies are currently unprofitable: An active, quality-tilted approach to U.S. small caps could potentially enhance that buffer against downside risk. (The index’s profitable companies trade at an average of 13 times earnings, according to FTSE Russell.)
As we face the prospect of slowing growth, sticky inflation and higher-for-longer rates, we believe the key to equity allocations will likely be combining earnings quality and business resilience with valuations that price for pessimism rather than perfection. We think many of the winners of 2023 could struggle to make the cut, while smaller companies are starting to look attractive and could provide opportunities as the inflation, rates and growth backdrop begins to stabilize.
In Case You Missed It
- Bank of Japan Policy Rate: The BoJ will continue to conduct yield curve control, but with a more flexible approach; the 1% level now a reference point, rather than a ceiling
- S&P Case-Shiller Home Price Index: August home prices increased 0.4% month-over-month and increased 2.2% year-over-year (NSA); +0.9% month-over-month (SA)
- U.S. Consumer Confidence: -1.7 to 102.6 in October
- Eurozone 3Q GDP (Preliminary Estimate): -0.1% quarter-over-quarter
- Eurozone Consumer Price Index: +2.9% year-over-year in October
- FOMC Meeting: The FOMC made no change to its policy stance
- JOLTS Job Openings: +56k to 9,553k in September
- ISM Manufacturing Index: -2.3 to 46.7 in October
- U.S. Employment Report: Nonfarm payrolls increased 150k, and the unemployment rate increased to 3.9% in October
What to Watch For
- Tuesday, November 7:
- U.S. Consumer Credit
- Eurozone Producer Price Index
- Wednesday, November 8:
- China Consumer Price Index
- China Producer Price Index
- Friday, November 10:
- University of Michigan Consumer Sentiment (Preliminary)