S&P 500 earnings declined in 2022 by 18.0% and subsequently increased by 7.8% in 2023. Standard and Poor’s currently estimates that 2024 earnings for the S&P 500 index will be $216.61, representing 10.6% growth for the calendar year. At the current price level of 5,283.4, the S&P 500 Index sells at 24.4x 2024 estimated earnings.
There has been much commentary about the “Magnificent 7” (Microsoft, Amazon, Meta Platforms, Apple, Alphabet, Nvidia, and Tesla). The Magnificent 7 sell for roughly twice the P/E ratios than most other US stocks. While five of the stocks have high growth rates, Apple and Tesla have negative revenue growth when we compare the most recent quarter to a year ago.
Richard Bernstein Advisors (RBA) has this to say in their commentary about the divergence between the large cap tech stocks and the rest of the stock market.
Our work in the early-1990s demonstrated that stock market leadership narrows when profits cycles decelerate because fewer and fewer companies can accelerate or even maintain growth in an increasingly adverse environment. Markets effectively reflect Darwinistic survival of the fittest as earnings growth becomes increasingly scarce.
However, the opposite occurs when profits cycles accelerate. Markets tend to broaden as the cycle accelerates because an increasing number of companies are growing, and investors become comparison shoppers for growth.
RBA notes that a high percentage, 32% of S&P 500 companies, have more than 25% earnings growth based on the last 4 quarters. In their opinion, “profits are accelerating and credit conditions remain healthy.” They expect the performance of the stock market to broaden and the Magnificent 7 to “substantially underperform.”
The Atlanta Fed’s GDPNow forecast for the second quarter has declined during the last month from 4.1% to 1.8%. A slowdown in economic growth will make it difficult to sustain earnings growth for many companies.
One of the reasons why small capitalization companies have been underperforming the S&P 500 since 2021 is that they typically have a higher debt load with a greater proportion of variable rate debt. Interest rates have been rising since June 2020, so small companies with more interest-sensitive debt have suffered. According to Pacer Financial, an ETF provider, the S&P Small Cap 600 has net debt/EBITDA (earnings before income tax, depreciation, and amortization) of 3.5 compared to 1.4 for the S&P 500.
Pacer’s US Small Cap Cash Cows ETF (CALF), which is included in many portfolios, has a lower ratio of net debt/EBITDA at 1.26, but sells at a more attractive valuation than either index. CALF has a price/free cash flow ratio of 8 and a price/earnings ratio of 11.
While there are reasons to be concerned about the economic future of the country (see my May 3 blog, “Prepare for All Eventualities), some stocks offer better fundamentals and more attractive valuations than other stocks. Also, we deal in a world of probabilities rather than certainties, and an allocation to common stocks makes sense as a hedge against inflation.
If you have any questions or comments, please contact me.
Sincerely,
Robert G. Kahl
CFA, CPA, MBA