Transcript

Amada Agati:  

School might be out, but with second quarter earnings season upon us, it's time to deliver the market's mid-year report card. With Mega-cap tech still leading markets higher, it's tempting to just copy and paste last year's answers. But to ace the market pop quiz, we think it's worth reading the whole book instead of just the Cliffs Notes version, because earnings look a heck of a lot different than this time last year.

In this month's edition of Adding Alpha, we dig deeper into what's driving earnings growth and what it signals for the market's path forward. After six quarters of challenging earnings reports, it may finally be #EarningsGrowthSummer, and dare I say #ChristmasInJuly for investors.

Like last July, Mega-cap tech not only dominates the headlines but also the top and bottom lines leading in performance, revenues, and earnings.

Meanwhile, the rest of the market has lagged behind as companies continue to navigate the challenges from sustained high inflation and high interest rates.

Through July 1st, the S&P 500 is up 15.6% year to date, while the S&P 500 equally weighted index is up just 4.3%, a differential of more than 100 basis points.

This is market concentration on steroids.

Although the S&P 500 was able to post positive earnings growth overall in both 2022 and 2023, excluding the Magnificent Seven, earnings growth has actually been negative since the third quarter of 2022.

That’s seven straight quarters. 

While I’m not a big fan of slicing and dicing the index to get to a certain narrative, backing out the Mag 7 really is a better reflection of the current health of corporate America.

It’s still a tough backdrop out there for most. The good news is we expect Q2 earnings season to be an inflection point.

With earnings growth poised to finally turn positive again, Ex Mag 7 current estimates project earnings growth of about 8.9% year over year with the Mag 7 and about 5.1% without them.

In Amanda math, that's enough for the market to get a passing grade, at least for now.

To be fair, it's important to avoid looking at the summer's earnings growth through rose colored sunglasses.

After all, seven out of the 11 sectors saw negative revisions, and of the four positive ones, the only sector without top performing mega-cap stocks was energy, which benefited from a late quarter rally in oil prices. We also get a boost from easier comps.

Given the negative revisions, the forward P/E multiple is back above 21 times and back to the type of price to perfection valuations we had earlier in the cycle, when interest rates were at zero and the Fed was supplementing market liquidity with quantitative easing. But does that tell us the whole story?

When we look under the hood, the top seven stocks are trading at a forward P/E of more than 34 times, while the remaining 493 stocks are at about 18.6 times, which is still above the long term average, but not at extreme levels.

This may also help partially explain the durability of the recent market rally in the face of Nvidia's 13% decline over multiple trading days.

Markets seem largely unfazed, whereas there had been a lot of concern about the inherent fragility of the rally.

While we're eager to take the W on earnings, as long term investors, we want to see sustainable, broad based earnings growth supporting market performance.

We'll be keeping a close eye on revisions because this quarter's growth rates alone aren't enough to warrant a shift in market leadership for the second half of 2024.

Consensus still expects an impressive 11% growth for all of 2024, followed by another 14% in 2025. It's 7% and 13% if you exclude the Mag 7.

We view a broadening and earnings growth participation and durable positive revisions in sectors such as health care, financials and industrials as essential to solving this algebra equation.

That being said, there is some sunshine in the earnings forecast. For one, the longest earnings recession for the health care sector should finally come to an end as comps finally look easier this quarter.

The other positive is that despite ongoing headwinds from high inflation, the S&P 500 is expected to see margins expand again in Q2.

While we're 150 basis points off the cycle high for profit margins, which peaked in Q3 of 2021 at 14%, it is encouraging to see margin expansion so late in the cycle.