Earnings season prelude
The “Magnificent 7” – a group of dominant tech companies – have been major drivers of S&P 500 earnings growth in recent times. Once again, they are predicted to deliver the lion’s share of earnings with an average of 18.1% earnings growth, but the remaining companies in the index are only expected to reach 0.1% growth. Thus, the overall Q3 2024 earnings growth for the S&P 500 companies is projected to be a modest 3.4%.
However, the current earnings season shows a mixed picture so far. While more S&P 500 companies are exceeding earnings expectations compared to recent averages, the degree to which they are surpassing these expectations is lower. Furthermore, downward revisions in earnings estimates for certain sectors are impacting the overall earnings growth rate. For instance, the industrials and energy sectors are forecasted to post and average earnings decline of -8.4% Y/Y and -26% Y/Y, respectively.
Looking ahead, analysts anticipate double-digit earnings growth for both the “Magnificent 7” and the rest of the S&P 500 over the next five quarters. This suggests a positive outlook for the market, with broader participation in earnings growth beyond just the dominant tech companies. Certainly, the S&P 500’s forward 12-month PE of 22x is evidence that investors are confident that corporate earnings prospects are much brighter than the 3.4% expected in the current quarter.
Of course, earnings growth cannot be viewed in isolation. Interest rates and other macroeconomic factors need to be considered by investors when valuing stocks. Since the Fed’s September 18 rate cut, the 10-year US Treasury yield has risen by 50 bps to 4.2%. Strong jobs figures and a consensus view that the much-feared recession will be avoided have helped propel stock market indices to all time highs in recent weeks. The question on all of our minds is whether valuations are too high.
Valuation conundrum
A recently published report from David Kostin, Goldman Sachs’ chief U.S. equity strategist, casts doubt on future stock market returns given today’s high valuations and long period of exceptional returns. In fact, Mr. Kostin suggests that the S&P 500 may only produce an average annual return of 3% over the next decade. He is not alone, other prominent market prognosticators, such as Robert Shiller, have also published reports that illustrate today’s sky-high valuation metrics match or exceed levels of previous peaks, including the dotcom and the late 1920s bubbles. Even the renowned “Buffet Indicator,” a measurement of the stock market’s value as compared to the GDP of the U.S. economy, suggests the market is now trading at record levels, which is far above what can be sustained based on historical trends.
However, the economy and financial markets are different now. Central banks and regulators operate with a different set of tools, and the companies that comprise most of today’s value in the S&P 500 are less capital-intensive and grow free cash flow faster than their predecessors. And the world is more connected, efficient, and capable of adjusting to changes more rapidly. Take the Silicon Valley Bank crisis or the unwinding of the recent Japan carry-trade event of just a few months ago as examples. Both were resolved quickly and with very little lasting interruption to the economy, at least so far. Moreover, the supply and demand dynamics for high quality stocks, such as those represented in the S&P 500, is being propelled by corporate buy-backs, large cash balances in the hands of investors, and very limited supply in the form of IPOs and secondary offerings. Thus, one could argue, the stock market is rightfully valued at much higher levels using the same valuation metrics. Time will tell.
Is inflation dead?
The election is now less than two weeks away. There are big differences between the Trump and Harris agendas, but they seem to agree on one issue – the rising federal debt isn’t a focus of concern. Both candidates are promising all kinds of tax breaks and giveaways. Earlier this week, the legendary investor and trader Paul Tudor Jones opined on the unsustainable trajectory of our ballooning U.S. debt and the potential catastrophic consequence we may encounter if our leaders continue to ignore the problem.
For those that did not listen to Mr. Jones’ interview on CNBC, let me summarize. During the past 25 years, debt as a percent of U.S. GDP has grown from 40% to more than 100%. The problem is that the debt is growing at a much faster rate than the economy. The U.S. depends on investors (both domestic and foreign) to fund our deficits, which are now running at 7-8% of GDP, with no end in sight, up from 3% just a few years ago. Because of higher interest rates, the interest payment on the debt is now one of the government’s largest single line-item expenses, exceeding the amount the U.S. spends on defense.
A ”Minsky” moment
No one knows how long investors will continue to show up and purchase bonds at U.S. debt auctions if deficits continue to widen. It all depends on the collective confidence of investors. The risk is that a bond buyer strike may result in a sudden and rapid rise in interest rates. The Fed controls short-term interest rates, but long-term rates are more difficult to manage if confidence is lost. Economists would call such an event a “Minsky” moment, which refers to a collapse in the price of bonds and rise in yields. Such an event could have a devastating effect on the values of all assets, since the U.S. 10-year bond is widely viewed as the globe’s risk-free asset.
The actions needed to realign our fiscal path going forward will not be easy – tax increases, spending cuts, means testing for entitlements, etc. Mr. Jones’ conclusion is that inflating the debt away (i.e., growing the economy and asset prices faster than the debt is growing) is the historically successful way out of the current debt bubble. Unfortunately, until our politicians decide that this is a crisis, we must invest prudently knowing the risk is simply a feature of today’s market environment. Let’s hope there is some recognition of this problem once the election has passed.
Rapper Drake turns 38 today, actor Kevin Kline is 77 and former Australian Prime Minister Malcolm Turnbull is 70.
Christopher Gildea 610-260-2235