In the US, it's been a tale of two markets – the large technology/Artificial Intelligence (AI) adjacent names versus all others.
The remarkable 17% rally in the first half of this year has been driven by narrow market leadership in mega-cap technology stocks. The Magnificent 7 —NVIDIA, Amazon, Microsoft, Google, Meta, Apple, and Tesla —account for over 60% of the year-to-date gains.
Only 24% of stocks in the S&P 500 outperformed the index in the first half of the year, for the third-narrowest six-month period since 1986. Meanwhile, the equal weighted S&P 500 – a proxy for the average stock – is only up 5% this year.
Not Just Hype, Fundamentals Underpin the Rally
The tech sector's strong performance over the past year has undoubtedly been driven by AI momentum and bullishness towards both cyclical and structural growth prospects for large-cap tech. This performance is also grounded in the sector's robust earnings growth over the past 12 months, which has outpaced the broader market.
In the first quarter, earnings for the Magnificent 7 rose 51.8% year-on-year, compared to just 1.3% for the rest of the S&P 500. Rising earnings expectations have enabled markets to continue trending higher despite crowded positioning, especially in tech. Since tech companies began reporting last quarter, forward-looking earnings expectations have increased materially, with prices moving higher in lock-step.
Ultimately, the high expectations leave little room for disappointment. With Q2 earnings season now underway, we need to see these strong earnings growth numbers delivered in order to sustain the current rally.
Indeed, some of the biggest moves in US equity indices this year have come as a result of earnings catalysts. The recently reported sales miss from Nike, which resulted in an 18.4% drop in its stock price, and the better-than-expected deliveries for Tesla, which led to a 17.4% increase in its stock price, illustrate that outcomes relative to expectations are key. The risk heading into earnings season is that expectations are high, creating a challenging hurdle for many of the most crowded sectors. Any hint of disappointment in earnings or guidance could see these mega-caps selling off.
Path for Earnings is Broader
The Q2 earnings growth rate for the S&P 500 stands at 8.8%. If this rate holds, it will be the highest year-over-year earnings growth since Q1 2022's 9.4%. We continue to believe that a broadening out in US market participation will characterize the second half of 2024, supported by stronger and broader fundamentals.
Q2 earnings growth is anticipated to be widespread across the index, with eight of the eleven sectors expected to report year-over-year growth. Notably, four of these sectors—communication services, healthcare, tech, and energy, are forecast to report double-digit growth.
Earnings growth estimates appear more balanced across sectors going forward, which suggests that tech leadership may diminish, at least temporarily. A slowing but resilient economy will allow for sectors to enjoy broadening earnings growth. This will be a product of stabilising revenues, given the nominal GDP backdrop and an expansion of profit margins that are just beginning to improve in many sectors. Some of this progress will be aided by lower input price pressures from material costs and employee wages.
The percentage of S&P 500 companies with positive three-month percent changes in forward earnings rose to a bull-market high of 83% in the first week of July. This augurs well for a broadening of the stock market’s breadth.
A Soft Landing for US Valuations?
While earnings have been supportive, there are still concerns that the US market is expensive. The US market’s PE multiple remains elevated versus history (91st percentile) and versus the rest of world. We believe the PE rating of the US market, while full, is broadly justifiable based on track record and structural outlook for corporate earnings growth.
Even when referenced against a relatively short-term 3-year average PE, so as to account for the rising importance of the US tech sector, the US market at 21x expected earnings is currently 10% above the 3-year average. The all-time valuation peak for the US was close to 25x in the tech bubble of 2000, while the S&P 500 peaked at close to 22x in 2021.
We do not see the US market in bubble territory currently, and the earnings outlook appears promising. The US market valuation does look stretched, although that’s largely attributable to the Magnificent 7. While the median forward PE for the index is 17.8, the broad market is not overvalued.
Although valuations are not a great tool for market timing, we see current valuations as at least an amber light for US market prospects, particularly when combined with relatively elevated investor sentiment. Our base case is that US valuations compress moderately over the coming year as earnings growth reaccelerates.
Goldilocks and No Bears?
The now widespread embrace of the US soft landing scenario represents a point of vulnerability for near-term market prospects. While the narrow breadth of the recent rally warrants some caution, the pivotal US macro backdrop remains supportive.
Our base case remains that inflation will subside enough over the balance of the year for the Fed to cut rates twice, while economic activity will slow, but in an orderly fashion. This macro backdrop keeps us constructive despite some caution around current US valuations and signs of tech sector exuberance. We continue to believe that broader market participation will characterize the second half of 2024. However, this broader participation will require a clearer signal on growth, which we view as a prerequisite for market breadth to extend beyond mega-cap AI. We continue to monitor tail risks (macro and geopolitical) around our central case view.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
About Wilsons Advisory: Wilsons Advisory is a financial advisory firm focused on delivering strategic and investment advice for people with ambition – whether they be a private investor, corporate, fund manager or global institution. Its client-first, whole of firm approach allows Wilsons Advisory to partner with clients for the long-term and provide the wide range of financial and advisory services they may require throughout their financial future. Wilsons Advisory is staff-owned and has offices across Australia.
Disclaimer: This communication has been prepared by Wilsons Advisory and Stockbroking Limited (ACN 010 529 665; AFSL 238375) and/or Wilsons Corporate Finance Limited (ACN 057 547 323; AFSL 238383) (collectively “Wilsons Advisory”). It is being supplied to you solely for your information and no action should be taken on the basis of or in reliance on this communication. To the extent that any information prepared by Wilsons Advisory contains a financial product advice, it is general advice only and has been prepared by Wilsons Advisory without reference to your objectives, financial situation or needs. You should consider the appropriateness of the advice in light of your own objectives, financial situation and needs before following or relying on the advice. You should also obtain a copy of, and consider, any relevant disclosure document before making any decision to acquire or dispose of a financial product. Wilsons Advisory's Financial Services Guide is available at wilsonsadvisory.com.au/disclosures.
All investments carry risk. Different investment strategies can carry different levels of risk, depending on the assets that make up that strategy. The value of investments and the level of returns will vary. Future returns may differ from past returns and past performance is not a reliable guide to future performance. On that basis, any advice should not be relied on to make any investment decisions without first consulting with your financial adviser. If you do not currently have an adviser, please contact us and we would be happy to connect you with a Wilsons Advisory representative.
To the extent that any specific documents or products are referred to, please also ensure that you obtain the relevant disclosure documents such as Product Disclosure Statement(s), Prospectus(es) and Investment Program(s) before considering any related investments.
Wilsons Advisory and their associates may have received and may continue to receive fees from any company or companies referred to in this communication (the “Companies”) in relation to corporate advisory, underwriting or other professional investment services. Please see relevant Wilsons Advisory disclosures at www.wilsonsadvisory.com.au/disclosures.