We’ve gone through almost a year of very low expectations that companies have continually beaten, but that bar is about to get set significantly higher. Double-digit earnings growth is not out of the question given the low base many companies are being compared to from last year. But missing these numbers could hurt returns significantly given that the S&P 500 is currently valued at over 21x forward earnings estimates. Indeed, last quarter saw companies that missed earnings estimates punished more severely than average.
While the S&P 500 is expected to grow by 8.8 percent in Q2, analysts expect 28 percent year-over-year growth from the Magnificent Seven (i.e., Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) and only 4 percent growth from the rest of the index. As I mentioned in my midyear outlook post, the top companies are trading at a significant premium to the rest of the index, adding risk to their outlooks. Over the past month, valuations of the top 10 companies in the S&P 500 have moved significantly higher and are trading above a 34x forward earnings multiple. The rest of the index is trading at about half that valuation.
Looking at the communication services and tech sectors specifically, Meta, Alphabet, and Nvidia have driven a large portion of those earnings. Without Meta and Alphabet, the communication services sector would see growth of only 3.2 percent instead of the 18.4 percent expected by analysts. Similarly, without Nvidia, the tech sector would have growth expectations of only 6.9 percent.
As we’ve seen for the past several quarters, this is a top-heavy market from both a performance and earnings perspective. We believe this story is likely to continue for a few quarters.
Source: FactSet Consensus Analyst Estimates as of July 3, 2024
The big banks kick off earnings season tomorrow, and they compose 40 percent of the S&P 500 companies to report over the next two weeks. The financials sector makes up a little over 20 percent of the Russell 1000 Value Index and will be a big driver of whether the value index can start to catch up to the growth index. As a whole, the sector is expected to see earnings growth of 4.3 percent, which is below the average. But banks in particular are weighing down the sector, with an expected 10 percent earnings decline. They have seen sluggish loan growth and headwinds from provisioning for losses from credit cards and commercial real estate.
While it still may take another quarter or two, analysts expect earnings growth to bottom out in the third quarter and begin to rise in the fourth quarter. Financials are still valued at just over 120 percent of their 20-year average valuation, but that is right in the middle of the pack relative to other sectors. For comparison, tech is valued at 175 percent of its 20-year average.
Health care is the second-largest weight in the value index. It is projected to have the second-highest growth rate of any sector at 16.8 percent, behind only communication services and ahead of technology. Much of this is due to Merck, which took a big loss in Q2 2023 and is expected to see more normal earnings this quarter. Without Merck, the sector would be expected to see a 1.3 percent earnings decline.
Energy is expected to see solid growth in the quarter, even though it’s trading at a discount to its historical average. This is due primarily to the fact that analysts expect the growth to be short-lived.
While earnings expectations aren’t particularly high for the value sectors, the value index is trading well below its historical average discount, making the stakes for earnings season much less relative to the growth sectors.
Source: FactSet, FTSE Russell, NBER, J.P. Morgan Asset Management. Growth is represented by the Russell 1000 Growth Index and Value is represented by the Russell 1000 Value index. *Long-term averages are calculated monthly since December 1997. **Dividend yield is calculated as the next 12-month consensus divided by the most recent price. Guide to the Markets-U.S. Data as of July 9, 2024.
This quarter’s earnings bar is high for both the S&P 500 and the large growth companies. With analysts expecting growth of 8.1 percent and 17 percent, respectively, in the next two quarters, companies need to win on two fronts given the high multiples they are trading at. With rising expectations for next year’s earnings, now up to 15 percent, companies must continue to provide solid guidance for the future. Given that companies have averaged 7.5 percent earnings growth from 2001 to 2023, companies have a lot to prove over the next few quarters, beginning with the Q2 earnings season.
The Russell 1000 Growth Index is a market-capitalization weighted index of those firms in the Russell 1000 with higher price-to-book ratios and higher forecasted growth values.
The Russell 1000 Value Index is a market-capitalization weighted index of those firms in the Russell 1000 with lower price-to-book ratios and lower forecasted growth values.