The magnificent seven, revisited

Good morning. Just as Japan seems to be escaping deflation, China may be falling into it. Consumer prices in China were asleep in June, reflecting (among other problems) oversupply and a dearth of consumer confidence. Remember when buying the China recovery was an easy trade? Email us: [email protected] and [email protected].

What’s next for the magnificent seven?

The earnings that will matter most in this second-quarter earnings season will be those of the magnificent seven — Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. This is because (as we have been reminded daily for months now) these companies are doing virtually all of the work to keep the US market rising. If their stocks should crack in the second half, a good year for the stock market could quickly turn into a bad one. So it’s worth thinking about the set-up going into the reports, which will dribble out over the next month or so.

In early June we noted that, in terms of their financial profile, the big techs are a heterogeneous bunch. We summed up the point this way (we did not include Tesla then): 

Alphabet, Amazon, Apple and Microsoft are experiencing a valuation surge. Nvidia is undergoing a rapid reappraisal of its short-term earnings prospects. Meta is a little of both.

That point is worth revisiting and expanding on. In the table below, you can see the fantastic year-to-date returns for the stocks, as well as a decomposition of those returns between higher earnings estimates and rising valuations. Note two things in particular. First, outside of Meta and Tesla, what we have seen is pure valuation expansion. Second, the valuations of the companies fall into three categories: valued in line with the wider market (Alphabet and Meta), expensive (Apple and Microsoft), and wildly expensive (Amazon, Nvidia and Tesla; though price/earnings has never been a great metric for Amazon, which is run with cool indifference to profit). Data from Bloomberg:

Now consider, in the next table, growth expectations for the year ahead. The revenue growth bar is set high for Nvidia and Tesla. The others are expected to grow in the single digits. Earnings growth expectations, on the other hand, are all over the place. The expectations for much higher profit at Meta, driven by widening margins, is particularly striking:

Are these realistic expectations? For the most part they are consistent with the trend we have seen across the group of seven. Revenue growth has slowed as the pandemic heyday has slipped into the rear-view mirror:

Overall, how is the set-up for these crucial stocks? Performance has been red hot, driven mostly by higher valuations. Revenue growth expectations are broadly reasonable. The background, however, is challenging. This is a hyped group: artificial intelligence chatter, especially but not exclusively around Nvidia, has been intense. Just as importantly, for a long time the valuations of tech stocks were justified by reference to low long-term interest rates. But long-term rates are now rising. The fact that the argument linking valuations and rates was full of holes may not matter if people still believe it. In short, these are great companies, but the positioning is pretty unappetising.

The most appealing, from a purely financial point of view, are Microsoft and Alphabet. Alphabet has run up less than the others, has a reasonable valuation and expectations are not set too high. Microsoft is a bit more expensive, but has the advantage of selling mostly to business customers, who should keep investing even if the consumer pulls back (just look in the line chart above at its slow-but-steady performance over the past few years). Contrast that to, say, Alphabet’s more cyclical advertising machine or Apple’s consumer-driven business.

We are very keen to hear readers’ opinions on which of the magnificent seven will perform best over the remainder of the year. Email them to us.

The other 493

If equity analysts are to be believed, this earnings season is as bad as it gets for corporate profits.

Bottom-up estimates for the second quarter are forecasting flat revenues and a 6-8 per cent year-over-year earnings contraction, as high input costs drag on earnings per share. Then it’s right back to expansion in the third quarter, when the S&P 500 is expected to return to (meagre) growth. By next year, recession hand-wringing will be long gone, consensus estimates suggest. Earnings are expected to grow 12 per cent in 2024.

The second-quarter contraction reflects acute pain in a few sectors rather than a broad-based crunch. The energy industry is coming off the high of an oil price surge. Materials companies are coping with a sharp drop in sales as global growth sags. Healthcare is struggling with high input costs (it’s the pickleball plague!). But in many sectors, earnings look OK:

You’ll notice above the impressive earnings expansion at consumer discretionary companies, thanks in part to resilient growth. Nor is this all just Amazon and Tesla (see previous piece). In a note out yesterday, Ryan Grabinski of Strategas rounds up the companies seeing the most improvement in second-quarter expectations over the past three months. Travel is a consistent theme: Royal Caribbean, Delta, American Airlines, and two casinos (MGM and Las Vegas Sands) are all in the top 10. Business travel is back. 

Across the S&P 500, too, analysts have grown cheerier (that is, less negative) on earnings. A rise in earnings revision breadth — the number of analysts raising earnings estimates minus those lowering them — has lent support to rallying stocks, notes Mike Wilson of Morgan Stanley. He argues, however, that the S&P has run past what better revision breadth can justify (notice the divergence in Wilson’s chart below):

The fact that earnings expectations are not especially high, at the same time as the economy keeps surprising everyone with good news, gives us comfort about second-quarter results. Looking further out, though, things feel a bit precarious. Yes, growth is holding up, but rate increases, we have to assume, haven’t fully bitten yet. And steady growth isn’t the same as re-accelerating growth, which is what’s needed for 2024’s rosy earnings estimates to hold true. The fact that this year’s stock gains have come almost entirely from multiple expansion suggests the good news has to keep on coming if the market is going to keep on rising. This earnings season, watch the companies that give mediocre (but not necessarily terrible) forward guidance. If those stocks get brutalised, that’s a sign that expectations have been set too high, and that the months to come could be rough. (Ethan Wu)

One good read

The secret to making good market calls is not making too many of them, writes Howard Marks. As they say in baseball: wait for the fat pitches.