 | Horacio Coutino, Equities investment writer |
Q1 Earnings season in focus
Ahead of this earnings season kick-off on 12th April, with releases from several bellwether financials, strategists had warned that high valuations, with the S&P 500 PE at 20.4x and EV/EBITDA at 14.0x, both higher than the 3-year and 1-year averages -would make it difficult to justify if companies didn't deliver profit growth and guidance that exceeded analysts’ estimates. With consensus earnings estimates revised downward at the end of Q1 and a correction of equities underway, this earnings season represents a critical test for the market.
We are still in the early stage of the earnings season, but as of 19th April, with 14% of S&P 500 companies reporting actual results, 74% of companies have reported a positive EPS surprise, and 58% have beaten revenue estimates. What we have seen thus far is a decrease in blended earnings growth due to the Health Care sector and a slight increase in revenues growth due to the Financials sector.
A downward revision to Gilead Sciences' (Health Care) non-GAAP EPS estimates, prompted by the recent CymaBay acquisition, proved to be the most significant headwind for the index's overall earnings growth rate. This negative impact was partially mitigated by positive earnings surprises within the Financials sector. During the week of 15th April, the majority of analysts covering Gilead Sciences adjusted their Q1 estimates, resulting in a significant decline from a mean EPS of $1.58 in 12th April to -$1.54 today. Consequently, the blended earnings decline for the Health Care sector widened from -25.4% to -30.8%.
Within the Financials sector, positive EPS surprises from Goldman Sachs ($11.58 vs. $8.73) and Morgan Stanley ($2.02 vs. $1.67) acted as the primary drivers of earnings growth for the index. This strong performance is reflected in the blended earnings growth rate for the Financials sector, which climbed from 3.4% to 5.1% during the week of 15th April.
The S&P 500's blended earnings growth rate for the first quarter of 2024 currently stands at 0.5%. This figure combines actual results from companies that have reported with estimates for those yet to report. If this blended rate holds true, it will represent the 3rd consecutive quarter of Y/o/Y earnings growth for the index.
The Financials sector has emerged as a key contributor to the upward revision of the S&P 500's blended revenue growth rate since 31st March. This positive shift is primarily driven by revenue surprises reported by Progressive ($18.96 billion vs. $17.0 billion) and Goldman Sachs ($14.21 billion vs. $12.94 billion). The blended revenue growth rate for the Financials sector has climbed from 3.2% to 4.6% over this period.
Revenue growth continues a positive trend, with the blended Y/o/Y rate for Q1 2024 reaching 3.5%. The blended net profit margin for the S&P 500 in Q1 2024 stands at 11.2%.
Looking deeper, five sectors are expected to experience Y/o/Y net profit margin growth compared to Q1 2023. The Utilities (13.0% vs. 10.3%) and Information Technology (25.1% vs. 22.4%) sectors lead this positive trend. However, six sectors are projected to see a decline in net profit margins Y/o/Y. The Health Care (6.1% vs. 9.3%), Energy (9.8% vs. 12.5%), and Materials (8.8% vs. 11.2%) sectors are at the forefront of this decrease.
What has happened to markets overall?
The market's response to S&P 500 companies' earnings surprises in Q1 2024 deviates from historical averages. Companies exceeding earnings expectations have witnessed a muted reaction, with their average stock price remaining unchanged (0.0%) in the two-day window preceding and following the earnings release. The typical 5-year average price increase of +1.0% observed during this timeframe for companies with positive surprises.
Conversely, companies falling short of earnings expectations have experienced an amplified negative response. On average, their shares prices were -6.1% in the two-day window surrounding the earnings release. This is significantly steeper than the 5-year average of -2.3% witnessed for companies with negative surprises.
The S&P 500 is -2.45% since this earnings season began on 12th April, while the Financials and Health Care sectors have had mild, yet contrasting returns, at +1.11% and -0.16%, respectively.
Emerging themes from this earnings season
This earnings season it’s not about today’s expectations, it’s about tomorrow’s. Financials kicked off the earnings season in high gear, with bellwether financials JPMorgan Chase, Wells Fargo, Citigroup, and Bank of America among the first to report. Net interest income came under pressure as deposit costs have risen along with higher interest rates. However, investment banking and underwriting fees, as well as higher credit card transaction volume in Q1 coupled with resilient credit quality, propelled the banks’ bottom line to exceed analysts' EPS estimates. After an initial adverse reaction to banks’ anticlimactic guidance for the remainder of 2024, sentiment has since recovered. Nasdaq’s KBW Bank Index has climbed 4.03% since 12th April.
The canary in the coal mine? The week of 15th April, major semiconductor manufacturers such as TSMC, SMCI, and ASML witnessed a plunge in share prices following their earnings reports. While all three companies met or exceeded analyst expectations for revenue and net profit, a more cautious outlook and guidance for the year dampened investor enthusiasm, raising concerns that the momentum behind AI might be fading.
SMCI experienced a 23.14% sell-off following the release of its Q1 2024 earnings report, sending ripples through the broader semiconductor and AI space. This led to Nvidia experiencing its worst trading day since March 2020, dropping 10%. This set in place a wider shift in AI. with the focus now on future outlooks and guidance to determine whether lofty AI expectations across various industries can be sustained.
Softer guidance indicating decelerating momentum in the AI space will likely affect the Magnificent Seven, with repercussions for the broader market. Five of its constituents are projected to be the top five contributors to Y/o/Y earnings growth for the S&P 500 for Q1 2024. These five companies (in order of highest to lowest contribution) are Nvidia, Amazon, Meta Platforms, Alphabet, and Microsoft.
While the Information Technology sector is expected to boast a 20.3% Y/o/Y earnings growth rate, Nvidia’s surge from $1.09 to $5.58 EPS is a major driver. Excluding it, the sector's growth shrinks to 7.5%. A similar story unfolds in Communication Services (20.1% growth) and Consumer Discretionary (15.4% growth), where Meta Platforms and Amazon, respectively, hold outsized influence. Without these companies, Communication Services dips to 9.9% Y/o/Y growth and Consumer Discretionary falls into negative territory (-2.7%).
From Magnificent Seven to Big Six? Two of the Magnificent Seven companies have reported earnings so far this week, Tesla and Meta Platforms, with different narratives of market sentiment emerging based on future expectations.
Meta Platforms delivered a stellar first quarter, with a 27% Y/o/Y revenue increase to $36.5 billion. This is credited to advancements in AI that have significantly enhanced ad-targeting capabilities, allowing Meta to overcome revenue challenges caused by privacy changes implemented by Apple. Furthermore, Meta's net profit for Q1 2024 skyrocketed to $12.4 billion, a 216.6% Y/o/Y increase.
Meta revised their 2024 capital expenditure projections upwards, with a new range of $35 billion to $40 billion, exceeding the previous estimate of $30 billion to $37 billion. However, Meta's Q 2024 revenue forecast of $36.5 billion to $39 billion fell short of analyst expectations, triggering investor apprehension before the earnings call. This conservative outlook, coupled with rising capex, overshadowed the positive first-quarter performance and triggered a stock price drop exceeding 15%.
Tesla presented a contrasting narrative. CEO Elon Musk addressed Wall Street's concerns by outlining a renewed focus on producing more affordable electric vehicles during the company's recent earnings call. This strategic shift comes in response to a challenging Q1 2024 marked by a significant decline in profits to their lowest level since 2021. Tesla's operating margin also experienced a substantial decrease, dropping from 11.4% to 5.5% Y/o/Y.
Musk further emphasised Tesla's commitment to developing a fully autonomous car. He unveiled details concerning a dedicated robotaxi model and a corresponding ride-hailing network. Musk playfully hinted at a potential name for the robotaxi – the "Cybercab" – scheduled for unveiling on 8th August.
Despite Musk’s ambitious promises, Tesla faces significant headwinds. Its existing vehicle lineup is experiencing declining demand and price pressures from competitors. The company's free cash flow turned negative in Q1 2024, with a net loss of approximately $2.5 billion. Tesla's unsold vehicle inventory also climbed to a 28-day supply, compared to 15 days in the previous year. The Company’s shares price surged over 10% in after-hours trading, following Musk’s promises of accelerating the launch of new cars and robotaxi.
Global backdrop
In April, all major global equity indices experienced declines, driven primarily by losses in the technology-related sector. Equity performance in April has been marked by a pivotal shift in investors’ expectations around rate cuts and borrowing costs this year following 3 consecutive months of higher than expected US inflation readings which caused yields to surge.
- According to the CME FedWatch tool, interest rate swaps now have priced in a 30.4% of probability that the range of the Fed target rate will continue to be 5 - 5.25% in its 18th September meeting, in contrast with 1st April pricing, that assigned a probability of 36.8% to the same Fed rate.
- Yields have continued their upward momentum in April. The US 10-year yield is up 34 basis points to 4.65%, while the 10-year German Bund is up 19 basis points to 2.59%. The spread between both securities of 206 basis points is 15.9 basis points higher than it was at the beginning of the month (190.1 basis points).
- The US dollar strengthened in April. The US Dollar Index, at 105.86, has risen 1.32% this month and +4.46% YTD. The FTSE 100 and the Stoxx Europe 600 indices declined to a lesser extent than their US counterparts in local currencies. The euro is -0.84% MTD against the dollar, while Sterling is -1.32% MTD.
Regional breakdown
US
S&P 500 -3.48% MTD +6.33% YTD
Nasdaq 100 -3.99% MTD +4.17% YTD
Dow Jones -3.38% MTD +2.05% YTD
Russell 1000 -3.55% MTD +6.00% YTD
Note: As of 4pm ET 24 April 2024.
In March, the S&P 500 witnessed the most instances of 52-week highs in nearly three years, according to BTIG Research. While such surges seldom mark an absolute market peak, their impact on near-term returns can be far more diverse. Past instances have seen similar spikes precede significant drawdowns, as in 2018 and 2020. Conversely, they have also coincided with robust uptrends, such as those observed in 2017, 2020, and 2021.
The S&P 500 rally that saw the index rise for 5 consecutive months in March and achieve several milestones in the first quarter of the year, appears to be over. For the S&P 500, April has so far resulted in 3 consecutive weekly losses, all led by interest-rate sensitive sectors Real Estate and Information Technology. This may be reflective of investors assessing equity valuations and pricing in the rise in Fed caution and increased likelihood of a “higher for longer” rate cycle.
The Fed has adopted a more cautionary tone since 10th April, when March inflation showed a higher than expected rise for the third consecutive month. On 16th April, Fed Chair Jerome Powell stated that, "The recent data have clearly not given us greater confidence and instead indicate that it is likely to take longer than expected to achieve that confidence." He made clear the Fed’s stance, saying, “Right now, given the strength of the labour market and progress on inflation so far, it’s appropriate to allow restrictive policy further time to work.” On 19th April Chicago Fed President Austan Golsbee acknowledged the strength of the labour market and recent plateauing of inflation reduction efforts, and emphasised the need for reevaluation and a data-driven approach moving forward saying, "I think we have to recalibrate and we have to wait and see."
With the exception of the Energy sector, the rest of the S&P 500 sectors are in negative territory so far this month.The Equal Weight version of the S&P 500 has underperformed the benchmark so far this year by 293 basis points at 1.21% YTD, and has experienced a slightly greater decline, registering -5.76% MTD vs S&P 500’s -5.46% MTD.
An analysis of the past five years (60 months) reveals that the current performance of the S&P 500, Nasdaq 100, and Dow Jones Industrials Average for April MTD falls within a weak historical range. All three indices rank at the 11.8th percentile, meaning only 7 out of the past 60 months have seen a weaker performance by this point in the month.
The Russell 1000 also exhibits a slightly stronger MTD performance in April 2024, ranking at the 13.5th percentile. This translates to just 8 months in the past 60 where the Russell 1000 experienced a lower return than its current -5.58% MTD performance.
The S&P 500's market breadth, as measured by the difference between the S&P 500 Equal Weight Index and the S&P 500 Index, reveals contrasting trends. While the spread has been predominantly negative for most of April, currently sitting at -0.09 percentage points over the past 60 trading sessions, the shorter 20-day window (from 25th March to 19th April) displays a positive spread of 0.88 percentage points.
Europe
Stoxx Europe 600 -1.38% MTD +5.56% YTD
Germany DAX -2.18% MTD +7.98% YTD
FTSE 100 -4.43% MTD +3.97% YTD
France CAC 40 -1.39% MTD +7.27% YTD
MSCI Europe -1.29% MTD +6.58% YTD
European equities also experienced a reversal of fortune in April. Following a record-breaking five consecutive months of gains, the Stoxx Europe 600 index, a broad measure of European stock performance, is -1.38% in April MTD. This retreat marks the first time since November 2023 that the index has posted a monthly decline. During the rally the Stoxx 600 had reached a new high above 510 and achieved its longest winning streak since 2018.
The shift in sentiment stemmed from growing concerns regarding the pace of US disinflation, the changing timeline for the Fed to initiate rate cuts, and the number and overall level of rate cuts for this year. Since higher interest rates can dampen equity valuations, this shift in expectations has negatively impacted European markets.
This shift in market sentiment appears counterintuitive given recent signals from ECB officials. Despite internal disagreements regarding the pace of future rate cuts, there has been consistent messaging suggesting an imminent rate reduction in June. This may be due to the weaker economic conditions within the eurozone and a decline in inflation closer to the ECB's target of 2.0%.
However, some eurozone policymakers have voiced concerns about overly aggressive rate cuts when compared to the trajectory of US monetary policy. Their apprehension centres on the potential for a weakening euro and its subsequent inflationary consequences.
In terms of performance in April within the Stoxx 600, Basic Resources emerged as the leader, defying the broader market weakness. It is +5.66% MTD, although YTD it remains -0.60%. This could be due to factors like rising commodity prices or positive developments in specific resource segments.
The Oil & Gas sector also displayed relative strength, +4.03% in April. This is likely linked to ongoing concerns about geopolitical tensions and potential disruptions to oil supply, which have pushed up oil prices.
The technology sector experienced the most significant decline in April, -6.86%. This could be due to a recent selloff in major semiconductor companies or a reevaluation of growth prospects within the sector.
Several other sectors also experienced declines in April, ranging from -0.84% for Utilities to -5.28% for Insurance. It's important to note the YTD performance of these sectors, like Industrial Goods & Services (IG&S), still hold a positive return of +7.26% despite the April decline.
The Stoxx Europe 600 EW, which assigns equal weight to all companies within the index, provides a different perspective. While its MTD decline (-2.78%) is slightly steeper than the main index, its YTD performance (+1.49%) is lower. This suggests that the April decline was more evenly distributed across companies in the EW index, as opposed to the main index which may be more heavily influenced by the performance of large-cap companies.
European equity index performance over the past five years (60 months) reveals a stronger showing compared to their American counterparts in April 2024 (as of 19th April).
The CAC 40 and FTSE 100 currently reside above the 30th percentile, at 30.5% and 33.8% respectively. This translates to only 18 and 20 out of the past 60 months experiencing weaker performance than April 2024 so far.
The Stoxx Europe 600 follows closely behind at the 25.4th percentile, indicating that just 15 months in the past five years have seen a lower return. Germany's DAX exhibits the weakest performance among the European indices mentioned, currently sitting at the 13.5th percentile. This signifies that 52 of the past 60 months have seen a stronger performance for the DAX.
European Equities poised for growth on cyclical upswing? European equities appear poised for a period of growth, driven by a confluence of positive factors. This is due to two key elements: a strengthening European economic trajectory and attractive valuation discrepancies, particularly outside of the technology sector.
A report from Bloomberg on 8th April revealed that strategist teams at Goldman Sachs and Citigroup have identified cyclical stocks as potential leaders in the upcoming market rally. This positioning aligns strategically with Europe's inherent tilt towards cyclical sectors compared to the US market. This shift in focus represents a departure from the AI-driven fervour that dominated market performance in the first quarter of 2024.
Further bolstering this optimism are rising European Purchasing Managers' Indexes (PMIs), a resurgence in manufacturing activity, and the anticipated implementation of rate cuts starting in June. Consequently, Goldman Sachs analysts forecast that the Stoxx Europe 600 will outperform the S&P 500 over the next year, with a particular focus on potential opportunities within the small-cap segment.
Citigroup echoed this positive sentiment, highlighting Europe's attractive investment proposition due to its undervalued exposure to cyclical sectors. This exposure, coupled with potential tailwinds from broader market trends and potential stimulus measures in China, positions Europe to benefit significantly in the coming months.
The Stoxx Europe 600’s market breadth reveals greater uniformity in stock performance compared to its American counterparts. This is measured by the difference between the Stoxx Europe 600 Equal Weight Index (where all constituents have equal weight) and the standard Stoxx Europe 600 Index.
While the spread between these indices has been mostly negative throughout 2024, currently sitting at -0.96 percentage points over the past 60 trading days, a shorter-term view paints a different picture. The spread for the last 20 trading days is +0.03 percentage points and has remained positive for the past 18 sessions. This suggests a recent convergence in performance among Stoxx 600 constituents, indicating a more cohesive market compared to the US.
Cross regional comparisons
An analysis of current valuation multiples, such as Price-to-Earnings (PE) and Enterprise Value-to-EBITDA (EV/EBITDA), offers insights into potential overvaluation within stock markets. These multiples consider a company's profitability through the integration of Net Earnings or EBITDA over the past twelve months.
PE Multiple | US & Europe
As of 19th April, the S&P 500's PE ratio stood at 19.7x. This follows a high of 21.0x reached on 28th March and remains above its year-beginning level of 19.5x. The S&P 500's historical averages also provide context, with a 3-year PE ratio of 18.9x and a 1-year average of 19.1x.
The Stoxx Europe 600 presents a different picture. Its PE multiple experienced a slight decline from a 28th March high of 13.7x and currently sits at 13.3x. This represents a 3.9% increase compared to the beginning of the year (12.8x). Similarly, the Stoxx Europe 600's historical averages are lower, with a 3-year PE ratio of 13.4x and a 1-year average of 12.6x.
EV / EBITDA Multiple | US & Europe
The S&P 500's EV/EBITDA multiple currently sits at 13.5x. While this represents a slight decline from its 28th March peak of 14.3x, it remains marginally above its year-beginning level of 13.4x. Historical context suggests that the current valuation is slightly above the 3-year average (13.1x) and the 1-year average (13.2x).
It is a different picture for the Stoxx Europe 600 with a significantly lower current EV/EBITDA multiple of 8.9x. This reflects a modest decline from its 28th March high of 9.2x and represents a 1.8% increase compared to the beginning of the year (8.7x). Historically, the Stoxx Europe 600 has traded at lower valuations, with a 3-year average EV/EBITDA ratio of 8.9x and a 1-year average of 8.6x.
This comparison reveals a clear disparity in valuations between the S&P 500 and the Stoxx Europe 600. The S&P 500 currently trades at a premium, with both its current and historical averages exceeding those of the Stoxx Europe 600. This suggests that European equities may offer relatively more attractive valuations compared to their US counterparts.
Equity Risk Premium | US & Europe
In a comprehensive analysis of equity market attractiveness, it's crucial to consider the relationship between equities and other asset classes, particularly sovereign bonds.
The equity risk premium is a metric that attempts to quantify the additional return an investor expects from equities compared to the perceived lower risk of holding sovereign bonds, typically represented by the yield on a 10-year government bond. A lower equity risk premium suggests that equities are less attractive relative to sovereign bonds, potentially signalling overvaluation.
The S&P 500 presents a concerning picture. Its current earnings yield of 0.45% is close to an all-time low, reflecting a long-term trend of rising valuations and potentially declining expected profitability. As of 19th April, the S&P 500's equity risk premium stood at 5.078%, a mere 50 basis points above the current yield of the US 10-year Treasury note. This suggests that the S&P 500 may be approaching the point where it becomes less competitive compared to sovereign bonds, particularly if bond yields continue to rise.
The Stoxx Europe 600 exhibits a more favourable dynamic. While its equity risk premium has also been declining, the decrease is not as pronounced as the S&P 500. This can be attributed to a higher starting point for the Stoxx Europe 600's PE ratio, potentially reflecting lower overall valuations in European equities. Additionally, lower European interest rates contribute to a more attractive equity risk premium for the Stoxx Europe 600, currently sitting at 5.03%.
Conclusions
In summary, the Q1 2024 earnings season will be marked by a careful balancing act between delivering positive earnings surprises and setting an upbeat forward guidance, able to keep investors’ hopes alive.
Given recent market developments, investor sentiment seems to be heavily influenced by expectations of future growth, particularly in the technology and communications space.
Without the contribution of the Magnificent Seven, the growth rates for their respective sectors would be significantly lower. This underscores the outsized influence certain companies have on market perception and the importance of disaggregating sector performance to understand underlying trends.
For equity investors, a crucial factor in maintaining a risk-on sentiment is the expectation of escalating growth within a company's core segments. This anticipated growth acts as a powerful counterweight to the gravitational pull of high interest rates. In essence, strong anticipated growth in a company's core business allows it to offer investors a compelling risk-reward proposition: the potential for significant future returns that outweigh the immediate headwinds of a more expensive borrowing environment.
With the prospect of lower interest rates diminishing and the potential fragility of the AI narrative being revealed, a shift in focus is necessary. It's crucial to identify sectors and companies with strong underlying fundamentals that can not only withstand a more restrictive monetary policy but also outperform expectations.
On a regional level, Europe emerges as a potentially outperforming market. This can be attributed to two key factors: an improving economic outlook and the potential for a more accommodative monetary policy compared to other developed markets. This scenario suggests an upward trajectory for the European Equity Risk Premium, widening the gap with its American counterpart. In simpler terms, European stocks could potentially offer a more attractive risk-reward profile due to the anticipated economic conditions and potential for lower interest rates.
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