This past week was dominated by politics. While I will leave the questions surrounding the future of Biden’s candidacy to others, I would note that investors don’t tend to factor in the unknowns until the outcomes become more obvious than they are today. As Trump’s likelihood to become President rose in the aftermath of the debate, the reaction was clearly muted in large part because his opponent is uncertain. Until that picture becomes better clarified, markets will remain focused on the economy, earnings and inflation.
This is likely to be a quiet week for the market. The one data point that could be market moving will be Thursday’s release of June’s CPI. May’s numbers showed slowing in the overall rate of inflation. Investors would like to see that continue through June. So would the Federal Reserve. Chairman Jerome Powell is scheduled to speak to Congress this week before the CPI release. While traders will hang on every word, Mr. Powell has largely played out his hand in recent weeks. A first rate cut could come as soon as September if (1) inflation continues to moderate, and (2) slack in the labor force continues. Last Friday’s employment report suggested that labor markets are less tight than just a few months ago. He will note that. Wage pressures are also lessening, another positive. But any rate cut will still be dependent on data between now and mid-September when the FOMC meets. In addition, Mr. Powell’s speech at the annual Fed meeting in Jackson Hole in August would likely be the right timing for any shift in commentary, not his meetings this week in Washington. Besides, it’s the 10-year Treasury yield that should be the focus of stock market investors, not the Fed Funds rate. While lower inflationary pressures have helped to push that rate down in recent weeks, rates have seemed to stabilize around the 4.25% range.
In part, the lower inflationary outlook stems from a slowdown in overall growth. Forecasts, including the prominent GDP Now model published in real time by the Atlanta Fed, shows growth slowed in the second quarter to 1-2%. That is consistent with both an unemployment rate edging up to 4.1% and weekly jobless claims inching up to about 240,000. The Fed has a dual mandate of price stability and promoting economic growth. Obviously, inflation falls with declining demand. The two mandates are often in conflict. For the past year, getting inflation under control has been the dominant focus. But with data increasingly supporting the notion that inflation is working back toward the Fed’s 2% target, more attention will need to be paid to ensuring that growth doesn’t slip much further. Given the lagging impact of interest rate setting policy, starting to lower rates too late risks triggering a recession. Thus, the Fed is still trying to thread the needle using restrictive monetary policy to reduce inflation, knowing that the same policies are likely to limit near-term growth. I think it is safe to say, the needle hasn’t been threaded yet.
Besides the market’s focus on interest rates, inflation and the Fed, investors also need to be aware that valuations remain higher. The market P/E, based on current GAAP earnings estimates is 28. Take out the “Magnificent 7” and it is closer to 19, still above historic averages.
So much has been written about the disparity between the fortunes of the top stocks and the rest of the market, it is hard to add much to that dialogue. But, hey, I’m going to try and bring that into a degree of focus.
I will start by reducing the Magnificent seven to six, eliminating Tesla. I do so for several reasons. First, the other six are all tech related names whose fortunes are tied together in some fashion. Second, so much of Tesla’s valuation is speculation of its addressable markets beyond the sales and earnings derived from the sale of its current slate of electric vehicles. I have nothing to add to the debate over whether Tesla will become a major player in electric storage, robo taxis, or any other venture. But I can say its current valuation, if only based on what it might earn selling EVs over the foreseeable future, is out of line.
So, let me focus on the other six, Nvidia#, Microsoft#, Apple#, Alphabet#, Meta Platforms#, and Amazon#. I will use the following data for my analysis; the current price of each stock, and the current P/E ratio based on historic data through the most recently reported quarter. I will also factor in the long-term growth rates, as compiled by FactSet, for each.
Using those numbers, the composite growth rate of the six is 22.9%. The outlier is Nvidia. Excluding that, the composite is still 18.7%, roughly double the growth rate expected for the overall S&P. Such growth deserves a premium valuation. Wouldn’t you pay more for a company growing 18% per year than one growing less than 10% annually? Well, the market does just that. The average P/E of the six, again based on historical numbers, is 35.8. The comparable number for the S&P today, based on reported GAAP numbers, is 28. Excluding these six, the rest of the market has a P/E of about 19.
Investors love to look at something called the PEG ratio whose numerator is a stock’s current P/E and whose denominator is the expected growth rate. The PEG of the S&P 500 is currently 1.36. For the sexy 6, it is 1.56. If I extract the 6 and look at the PEG ratio for the other 494 stocks in the S&P, the PEG ratio is closer to 1.5, almost identical to the PEG ratio of the six leaders.
Looking backwards, it is obvious, that owning these six in some fashion was a necessary component to achieve respectable returns in this market. It is also worth repeating that in both the fourth quarter of 2023 and during the first quarter of this year, reported earnings for the 494 lower S&P 500 companies were lower than a year earlier. Thus, while corporate earnings have risen over the past year, the entire gain and then some was achieved by these six companies.
Looking forward, earnings estimates for the 494 are improving but not as much as the macro forecasts indicate. Estimated earnings for all of 2024 for the S&P 500 are estimated to increase 7-8%. But without the top 6, that number is barely positive. Next year, the overall number is over 10%, but no more than mid-single digits for the rest.
The obvious conclusions are:
1. The radical outperformance of the big six companies is justified by the earnings growth they achieved.
2. Based on PEG ratio analysis, these six companies are not overvalued versus the other 494 based on current data and future expectations.
3. This analysis doesn’t answer the question whether the market as a whole is cheap, fairly valued, or overpriced.
4. Future performance will be dictated by the abilities of all companies to match, exceed or miss achieving future expectations.
Stepping away from the numbers, what we are witnessing today is a massive technology revolution, one that has the potential to increase productivity like nothing we have witnessed in decades. So far, this is more promise than reality. Computers get smarter and smarter, able to achieve more and more in less time. At the same time, man can only get incrementally smarter using computers to achieve solutions quicker and faster. Before long, we will be able to “converse” with computers effectively. Applications like ChatGPT are making great strides in that direction. Answers to queries lead to better follow-up questions and more precise outcomes. Speech will replace keyboard strokes. Soon typing in arcane URL codes, memorizing passwords, etc. will disappear. Queries and responses will be in plain English. A programmer will ask an AI enabled computer to write a piece of code or a patch and the response will be instantaneous. Companies like the Big Six we have been mentioning will reap the benefits. So will others as they incorporate AI to improve customer service, increase speed, and reduce costs.
The bottom line is that the big six stocks will remain superior performers as long as future earnings match or exceed expectations. We are in the very early innings of the AI revolution. Some of the top names today will not be the leaders tomorrow. Just as Facebook obsoleted MySpace, and Google supplanted Yahoo, disruptive technologies will create changes in future leadership. Any truly disruptive company becomes a target for future competition, whether it be TikTok taking on Facebook, or Hoka sneakers taking share from Nike. It’s hard to stay king of the mountain. But until new leaders surface, these six are the best of what we have. The future for Nvidia and Microsoft seems a lot more exciting than the future for US Steel or General Motors.
Today, Kevin Bacon is 66. Anjelica Huston turns 73.
James M. Meyer, CFA 610-260-2220