 | Horacio Coutino, Equities investment writer |
As earnings season progresses, S&P 500 companies continue to demonstrate strong performance relative to expectations. The proportion of companies reporting positive earnings surprises exceed their 10-year averages. However, the magnitude of these surprises above expectations (surprise factor) is below their 10-year average. The S&P 500 is currently exhibiting its highest earnings y/o/y growth rate since the second quarter of 2022.
To date, 41% of S&P 500 companies have reported their actual Q2 2024 results, with 78% surpassing EPS estimates. This figure exceeds both the 5-year average of 77% and the 10-year average of 74%.
The blended earnings growth rate for the first quarter currently stands at 9.8%, an increase from the 8.9% growth rate reported at the end of the quarter (30th June). If this 9.8% figure holds, it will represent the index's highest y/o/y earnings growth since Q4 2021, when it was 31.4% and is 3.9 percentage points higher than last quarter at 5.9%. It will also mark the fourth consecutive quarter of y/o/y earnings growth.
Since 30th June, companies have been reporting earnings 4.4% above expectations. This surprise factor is below the 1-year average (+6.4%), 5-year average (+8.5%), and 10-year average (+6.7%). The Materials sector (+7.5%) leads in positive aggregate difference between actual and estimated earnings, followed by Health Care (+6.8%) and Financials (+6.1%).
Regarding revenue, 60% of S&P 500 companies have surpassed earnings estimates, slightly below the 5-year average of 69% and the 10-year average of 64%. Aggregate revenues are 1.1% above estimates, a figure significantly lower than the 5-year average of 2.0% and the 10-year average of 1.4%.
Positive revenue surprises from companies within the Energy and Materials sectors have been the primary drivers of the index's increased revenue growth rate since 30th June, each contributing +2.3%. Conversely, the Utilities sector experienced the largest negative difference between actual and estimated revenues, at -2.6%. Collectively, the blended revenue growth rate for the second quarter is currently 5.0%. This figure represents an increase from the 4.7% rate recorded at the end of the quarter.
The forward 12-month price-to-earnings (P/E) ratio is 20.6x, surpassing both the 5-year average of 19.3x and 10-year average of 17.8x. However, this figure remains below the 21.0x recorded at the end of the second quarter (30th June).
171 S&P 500 companies are scheduled to report their second-quarter results the week of 29th July.
S&P 500 Earnings Growth: 9.8%
Eight of the eleven sectors have reported or are projected to report y/o/y earnings growth for Q1 2024. The Communication Services, Information Technology, Financials, and Health Care sectors lead this growth. Conversely, Materials, Industrials and Energy sectors have recorded a y/o/y decline in earnings.
The Communication Services sector stands out with the highest y/o/y earnings growth rate among all sectors, at +20.7%. Meta Platforms and Alphabet have significantly contributed to this growth, with earnings per share (EPS) of $4.70 (versus $2.98) and $1.89 (versus $1.44), respectively. Without these two companies, the sector's blended y/o/y earnings growth rate would fall to +4.4%.
Information Technology closely follows with the second-highest growth rate at +17.2%. Unsurprisingly, Nvidia ($0.64 vs. $0.27) is the largest contributor to the sector's growth, and its exclusion would lower the blended y/o/y earnings growth rate to +7.8%.
Financials reports the third-highest y/o/y earnings growth rate at 15.0%. Within this sector, all five industries are reporting y/o/y earnings growth. Three of these industries are reporting double-digit increases: Insurance (+32%), Consumer Finance (+27%), and Capital Markets (+27%). Excluding the Insurance and Capital Markets industries would reduce the sector's overall growth rate almost by half to +8.4%.
Health Care follows with a growth rate of +12.0%, largely attributed to Merck's EPS of $2.16, a significant increase from the previous year's loss per share of $2.06. Excluding Merck would lead to the Health Care sector reporting a y/o/y decline in earnings of -5.8% . Conversely, Vertex Pharmaceuticals, with an earnings deviation of $11.70 loss per share compared to the estimated EPS of $3.89, is the primary factor hindering earnings growth in the sector. Excluding this company, the blended earnings growth rate for the Health Care sector would rise significantly to +19.3%.
Materials experienced the most substantial y/o/y earnings decline of all sectors, at -10.3%. In terms of industry performance, three of the four sectors within this industry are anticipated to experience a y/o/y decline in revenues: Containers & Packaging (-19%), Metals & Mining (-16%), and Chemicals (-8%). Conversely, Construction Materials, stands as the sole industry projecting y/o/y revenue growth of +1%.
The Energy sector will command significant market attention this week with the release of ExxonMobil and Chevron's earnings reports on 2nd August. While the average oil price increased by +9.7% ý/o/y in Q2 2024 compared to Q2 2023 ($80.66 vs. $73.56), the Energy sector is experiencing the third-largest y/o/y earnings decline among the eleven S&P 500 sectors for Q2 2024, registering a contraction of -0.8%.
It is noteworthy that the Energy sector has also undergone the most substantial decline in earnings across all sectors since the end of the second quarter. On 30th June, the estimated earnings growth for the sector in Q2 stood at +13.3%. However, current reports reveal a y/o/y blended earnings decline of -0.8%. This significant downward revision in earnings is primarily attributed to analysts lowering Q2 earnings estimates for prominent companies in the sector since 30th June, including ExxonMobil (to $2.03 from $2.37), Marathon Petroleum (to $3.22 from $5.07), and Chevron (to $2.93 from $3.27).
Despite this month's decline in earnings expectations, four of the five industries within the sector are reporting y/o/y earnings growth: Oil & Gas Exploration & Production (+21%), Oil & Gas Equipment & Services (+18%), Oil & Gas Storage & Transportation (+8%), and Integrated Oil & Gas (+7%). Conversely, the Oil & Gas Refining & Marketing industry is the sole outlier, experiencing a y/o/y earnings decline of -52% for the quarter.
Looking ahead, analysts anticipate further earnings declines in the Energy sector for Q3 2024 and Q4 2024, projecting contractions of -7.1% and -1.6%, respectively.
S&P 500 Net Profit margin: 12.1%
The blended net profit margin for the S&P 500 in Q2 2024 reached 12.1%, surpassing the previous quarter's net profit margin of 11.8%, the 5-year average of +11.5% , and the year-ago net profit margin of +11.6% .
Sector-specific analysis reveals that eight sectors experienced a y/o/y increase in their net profit margins in Q2 2024 compared to Q2 2023. Leading this growth were the Financials with 1.7 percentage points (18.4% vs. 16.7%), Information Technology with 1.6 percentage points (24.9% vs. 23.3%), and Communication Services at 1.5 percentage points (13.4% vs. 11.9%). Conversely, five sectors reported y/o/y declines in their net profit margins led by Real Estate with 1.7 percentage points (35.0% vs. 36.7%).
Furthermore, six sectors reported Q2 2024 net profit margins exceeding their 5-year averages, with the Industrials (10.7% vs. 8.2%) and Consumer Discretionary (8.7% vs. 6.6%) sectors demonstrating the most significant increases. In contrast, foursectors reported Q2 2024 net profit margins below their 5-year averages, most notably the Health Care (8.0% vs. 9.8%).
The S&P 500 reaction to earnings
The market response to earnings surprises reported by S&P 500 companies has been asymmetrical. Positive surprises are being rewarded less than average, while negative surprises are being punished more than average.
Companies exceeding earnings expectations have seen an average price increase of +0.3% in the two-day window preceding and following the earnings release. This is a lower favourable reaction than the 5-year average price increase of +1.0% observed during this timeframe for companies with positive surprises.
Conversely, companies undershooting earnings expectations have experienced an amplified negative response. On average, their shares prices were -3.8% in the two-day window surrounding the earnings release. This is larger than the 5-year average of -2.3% witnessed for companies with negative surprises.
The S&P 500 is -2.40% since this earnings season began on 8th July.
Global backdrop
July saw a varied performance across major global equity indices, primarily driven by a significant rotation from technology and telecommunications sectors towards those that had underperformed earlier in the year. Notably, a shift from mega-cap stocks to small and mid-cap stocks was evident, as exemplified by the Russell 2000's impressive 9.45% month-to-date gain. Performance diverged between major European and US indices, with the former ending the month in positive territory while the latter experienced declines. Additionally, July witnessed the market solidifying its expectations of a September rate cut following subdued inflation data revealed in the Consumer Price Index (CPI) report released on 11th July.
- According to the CME FedWatch tool, interest rate swaps have now priced in a 87.7% probability that the Fed rate will be set lower, in the target range of 5 - 5.25% at its 18th September meeting. This contrasts with 30th June pricing which assigned a 47.41% probability to the same Fed rate on that date. Additionally, interest rate swaps have priced in an 11.9% probability of a 50 bps rate cut on that date.
- Yields have significantly declined across regions in July. The US 10-year yield was -36.7 basis points (bps) to 4.035%, while the 10-year German Bund was -19.6 bps to 2.305%. The spread between the two was 173.0 basis points. This was 17.1 bps lower than it was at the end of June.
- The US dollar weakened in July. The US Dollar Index, at 104.67, was -1.41%, while the YTD performance by 31st July was +2.99%. The euro was +1.16% against the dollar, while Sterling was +1.65% in July.
Regional breakdown
US
S&P 500 +1.13% MTD +15.78% YTD
Nasdaq 100 -4.50% MTD +11.71% YTD
Dow Jones +4.15% MTD+8.10% YTD
Russell 1000 +1.37% MTD +15.00% YTD
Note: As of 5pm EDT 31 July 2024.
Source: Factset
With the exception of the Information Technology and Communication Services sectors, all other S&P 500 sectors experienced positive performance in July. The Real Estate sector led the index's performance this month, +7.11%, followed by the Utilities sector at +6.73% and Financials +6.31%.
In contrast with June, the equal-weighted version of the S&P 500 outperformed the benchmark by 3.26 percentage points MTD, yielding a 4.39% return compared to the S&P 500's 1.13%. However, YTD the equal-weighted version has achieved a 8.64% return, compared to the S&P 500's 15.78%.
Source: Factset
An analysis of the past five years (60 months) demonstrates that the July performance of major US stock indices—the S&P 500, Nasdaq 100, Dow Jones Industrial Average, and Russell 1000—has been mixed. The S&P 500 and Russell 1000's July performance ranks at the 40.6th percentile and 44th percentile, respectively, signifying that 36 and 34 out of the past 60 months have witnessed superior performance. The Dow Jones Industrial Average's July performance of 4.41% ranks at its 79.6th percentile, making it the strongest among US indices. Meanwhile, the Nasdaq 100's negative performance ranks at the 28.8th percentile, indicating that only 17 months out of the past 60 have seen a more negative return than its current -1.63% .
Europe
Stoxx Europe 600 +1.13% MTD +8.18% YTD
Germany DAX +1.50% MTD +10.49% YTD
FTSE 100 +2.50% MTD and +8.21% YTD
France CAC 40 +0.70% MTD -0.15% YTD
Spain IBEX 35 +1.11% MTD +9.53% YTD
MSCI Europe +0.94% MTD +8.05% YTD
Source: Factset
In July, the Stoxx Europe 600 displayed a nuanced performance across its sectors, with 12 of its 17 sectors in positive territory. The Construction & Materials sector emerged as the frontrunner, +6.20%, followed by Banks +5.59% and Utilities at +5.58%.
Conversely, Technology was -6.05%. This negative performance may be attributed to raising concerns regarding stretched valuations as well as ‘overinvestment’ in AI.
A comparative analysis of the Stoxx Europe 600 Equal Weight (EW) index reveals a contrasting picture. The EW index, which assigns equal weight to each constituent company, posted a +2.95% return in July, outperforming the standard Stoxx Europe 600's +1.32%. Moreover, its YTD performance stands at +5.80%, 2.38 percentage points lower than the European benchmark. This suggests a more evenly distributed increase across companies within the EW index, whereas the main index may be disproportionately influenced by the performance of large-cap companies.
Source: Factset
An analysis of European equity index performance over the past five years (60 months) reveals more favourable results than their American counterparts in July 2024.
Stoxx Europe 600's and France’s CAC 40 July performance rank at the 45.7th percentile, indicating that 33 months within this timeframe have yielded higher returns. However in this time frame, Stoxx Europe 600’s performance is 0.62 percentage points superior. UK's FTSE 100 demonstrated the strongest performance at 2.49%, placing it at the 72.8th percentile.
Germany's DAX and the MSCI Europe resided above the 40th percentile, at 49.1% and 45.7%, respectively by 31st July. This implies that more than 30 of the past 60 months have seen stronger performance than July 2024 for these indices.
Spain’s Ibex 35 also exhibited a strong performance, positioned at the 59.3rd percentile, which implies that only 24 out of the past 60 months have witnessed stronger performance for the Spanish index.
As of 30th July, according to LSEG I/B/E/S data for the STOXX 600, Q2 2024 earnings are expected to increase 1.9% from Q2 2023. Excluding the Energy sector, earnings are expected to increase 1.0%. Q2 2024 revenue is expected to increase 0.2% from Q1 2023. Excluding the Energy sector, revenues are expected to increase 0.9%. Of the 152 companies in the STOXX 600 that have reported earnings by 30th July for Q2 2024, 53.9% reported results exceeding analyst estimates. In a typical quarter 54% beat analyst EPS estimates. Of the 179 companies in the STOXX 600 that have reported revenue by 30th July for Q2 2024, 58.7% reported revenue exceeding analyst estimates. In a typical quarter 58% beat analyst revenue estimates.
Health Care, at 73%, is the sector with most companies reporting above estimates. Financials, at 13%, is the sector that beat earnings expectations by the highest surprise factor. In the Real Estate sector only 25% of companies reported above estimates. Technology’s earnings surprise factor was the lowest at -7% . The STOXX 600 surprise factor is 5.2%. The forward four-quarter price-to-earnings ratio (P/E) for the STOXX 600 sits at 13.3x.
During this week, 40 companies are scheduled to report quarterly earnings.
Analysts expect positive Q2 earnings growth from 8 of the 15 countries represented in the STOXX 600 index. Portugal (41.2%) and Spain (25.8%) have the highest estimated earnings growth rates, while Ireland (-45.7%) and Poland (-15.5%) have the lowest estimated growth.
Small-cap resurgence disrupts Big Tech dominance
The stock market has experienced a notable shift in dynamics. Over the month of July there has been a resurgence in previously underperforming stocks, while the historically resilient "Magnificent Seven" technology group has faltered.
Dow Jones Market Data reveals that from 10th to 17th July, the Russell 2000 index of smaller stocks outperformed the S&P 500 by the widest margin for a period of that length since 1986. Concurrently, the Russell 1000 Value index achieved its most significant lead over its growth-stock counterpart since the aftermath of the dot-com bubble in April 2001.
Since 2023 the Fed has maintained elevated interest rates, prompting investors to seek refuge in large-cap companies. These companies are often favoured due to their established market dominance, operational scale, and relative insulation from economic volatility. Additionally, some of these companies are well-positioned to leverage potential advancements in artificial intelligence.
Aggregate index returns have been heavily concentrated in mega-cap technology stocks. Nvidia alone accounts for over a quarter of the S&P 500's 15.78% year-to-date total return. Combined with Microsoft, Apple, Alphabet, Amazon, and Meta Platforms, these six stocks contribute 8.6 percentage points, or 55%, of the total return.
This outperformance has driven US equity market concentration to its highest level in decades. These six stocks generate 21% of S&P 500 earnings and comprise approximately 30% of its market capitalization. Their current forward price-to-earnings multiple of 33.2x significantly surpasses the 16.4x multiple of the equal-weighted S&P 500 index.
The trade seemed unstoppable, and drove market concentration significantly higher, prompting concerns as to whether the levels of market concentration posed a significant risk to markets and if fundamentals support current levels of concentration.
However, a surprisingly benign inflation report on 11th July appears to have shifted investor sentiment. While expectations of Federal Reserve rate cuts had been growing, this data solidified expectations for these cuts to commence as early as September. Believing this shift to be imminent, investors began reducing their exposure to technology stocks and increasing their allocation to sectors expected to benefit from reduced borrowing costs and economic stimulus.
The small-cap index has experienced a significant 9.90% increase this month, bringing its year-to-date advance to 11.02%. Conversely, the S&P 500 has declined by 0.44%, reducing its gains to 13.98%. Consequently, the small-cap index now outperforms the equal-weighted S&P 500 by 2.9 percentage points year-to-date.
This shift has caught many investors off guard, leaving them perplexed about its underlying drivers. Against the current backdrop of extreme market concentration, we attribute this rotation to five key developments:
- Decelerating inflation data and the heightened probability of Federal Reserve rate cuts in September.
- Resilient economic growth data indicating continued stability.
- A notable increase in prediction market forecasts favouring a Donald Trump victory in the upcoming election, with Republicans potentially gaining Senate control and maintaining their House majority.
- Increased investor focus on the anticipated compression of the growth premium between large-cap stocks and the broader index.
- Growing concerns regarding the potential for overinvestment in AI technologies.
Decelerating inflation data. On 11th July, the Bureau of Labor Statistics reported a core Consumer Price Index (CPI) reading significantly below consensus expectations, standing at 3.27% y/o/y compared to the anticipated 3.4%. This represents a 41-month low and the slowest pace of core CPI inflation since January 2021. Furthermore, the University of Michigan's consumer sentiment survey, released on 12th July, revealed a modest decline in short-term and long-term inflation expectations. This confluence of data has strengthened market anticipation of forthcoming Federal Reserve rate cuts.
Resilient economic growth data. Solid economic growth data has accompanied the disinflationary readings. Core retail sales in July notably exceeded expectations, rising by 0.9%, a figure 0.7 percentage points above consensus forecasts. Additionally, on 25th July, data from the Bureau of Economic Analysis surpassed economists’ expectation of 2% GDP growth for the second quarter at 2.8%, and marked a jump from the first quarter’s 1.4% rate.
A notable increase in prediction market forecasts favouring a Donald Trump victory. The probability assigned by prediction markets to Trump winning the election increased by as much as 70%. Numerous investors consider small-cap stocks a prospective avenue for a ‘Trump trade’. This sentiment stems from the historical trend where small-cap equities demonstrated significant outperformance in the aftermath of Trump's election in 2016. Unlike large-cap counterparts, small caps exhibit heightened sensitivity to the US economic growth landscape. Moreover, their predominantly domestic focus renders them less susceptible to tariff impacts.
Narrowing growth premium of large-cap stocks. While Amazon, Google, Meta Platforms, Microsoft, and Nvidia are projected to experience a collective 37% growth in 2024 profits, outperforming the median S&P 500 stock's 5% growth, consensus estimates indicate a deceleration in their sales growth. Year-over-year sales growth for these five companies is expected to decline from 22% in Q1 2024 to 17% in Q2, followed by 16% in Q3 and 14% in Q4. Conversely, the median S&P 500 stock's sales growth, although starting from a lower base, is projected to accelerate from 2% y/o/y growth in Q2 to 3%, 4%, and 5% in the subsequent quarters. Additionally, Russell 2000 companies are anticipated to report an 18% rise in second-quarter profits, marking a reversal of the five-quarter trend of y/o/y declines, as per LSEG I/B/E/S data.
Heightened reservations regarding the risk of overinvestment within the AI sector. Concerns have arisen regarding the potential for overinvestment in artificial intelligence (AI), particularly among the four hyperscalers: Amazon, Meta Platforms, Microsoft, and Google. These companies collectively allocated $357 billion to capital expenditures and research and development in the last four quarters, representing a substantial 23% of total spending by all S&P 500 companies. Goldman Sachs expressed a sceptical perspective on 25th June, questioning AI's economic potential and its capacity to generate returns beyond the current "picks and shovels" phase. The firm also highlighted additional factors, such as chip shortages and potential power constraints, that could impede the growth of AI-related themes.
The broadening of this rally is a positive development, as it promotes a healthier and more stable market, potentially extending the duration of the bull market. However, sustained earnings growth is essential for the continuation of this upward trajectory.
The recent outperformance of small-cap stocks is expected to persist barring significant shifts in the macroeconomic environment, or if the second-quarter results of mega-cap technology companies lead to upward revisions in analysts' revenue forecasts for the coming quarters.
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