 | Horacio Coutino, Equities investment writer |
Q2 earnings season
As the conclusion of Q2 nears, it’s time to reassess earnings expectations before the onset of earnings season. Regarding Q2 guidance, the percentage of S&P 500 companies issuing negative EPS guidance aligns with historical averages. To date, 111 companies within the index have provided EPS guidance for the quarter, with 60% (67 out of 111) issuing negative guidance. This figure surpasses the 5-year average of 59% but remains below the 10-year average of 63%.
As of 25th June, the S&P 500 is projected to report a y/o/y earnings growth of 8.8%, slightly lower than the 9.0% estimated on 31st March. If realised, this growth rate would mark the highest since Q1 2022, when it reached 9.4%, and represent the fourth consecutive quarter of earnings growth for the index.
Earnings growth for Q2 is anticipated to be broad-based, with eight of the eleven sectors projected to report y/o/y increases. Four sectors are expected to achieve double-digit growth: Communication Services (+18.5%), Healthcare (+16.9%), Information Technology (+16.1%), and Energy (+14.7%). Three sectors, led by Materials (-9.3%), are predicted to experience a y/o/y earnings decline.
The estimated annual revenue growth rate for Q2 2024 remains consistent with the initial estimate at the start of the quarter, with the S&P 500 expected to report a 4.6% increase. If achieved, this would mark the 15th consecutive quarter of revenue growth for the index. Ten sectors are projected to exhibit y/o/y revenue growth, spearheaded by Information Technology (+9.4%) and Energy (+8.7%). However, the Materials sector is anticipated to experience a decline of -1.9%.
The estimated net profit margin for the S&P 500 for Q2 2024 is 12.0%, exceeding the previous quarter's margin of 11.8%. At the sector level, seven sectors are expected to report y/o/y expansion in net profit margins, led by Information Technology (+24.8% vs. +23.4%) and Communication Services (+13.1% vs. +11.9%). Conversely, four sectors are projected to report contractions, with the Real Estate sector experiencing the most significant decline (-35.3% vs. -36.7%).
Global backdrop
Major global equity indices have had a mixed performance in June, with the divergence primarily due to growth in the technology and telecommunications sectors. Robust earnings reports, continued enthusiasm for the potential of artificial intelligence (AI), and strong signs of economic resilience were also contributing factors. This growth occurred despite investors revising their expectations regarding the number and timing of potential interest rate cuts this year.
- According to the CME FedWatch tool, interest rate swaps have now priced in a 61.1% probability that the Fed rate will reduce the target range to 5-5.25% at its 18th September meeting. This contrasts with 31st May pricing which assigned a 47.01% probability to the same Fed rate on that date.
- Yields have declined across the curve in June. By 24th June the US 10-year yield is -26.5 basis points (bps) down to 4.237%, while the 10-year German Bund has declined -24.9 bps to 2.422%. The spread between the two was 181.5 bps. This was 1.6 bps lower than it was at the end of May, at 183.1 bps.
- The US dollar has risen slightly in June. The US Dollar Index, at 105.50, was +0.80%, while the YTD performance by 24th June was +4.12%. The euro was -1.06% against the dollar, while Sterling was -0.42%.
Regional breakdown
US
S&P 500 +3.23% MTD +14.22% YTD
Nasdaq 100 +5.06% MTD +15.74% YTD
Dow Jones +1.87% MTD +4.57% YTD
Russell 1000 +2.96% MTD +13.20% YTD
Note: As of 5pm EDT 24 June 2024.
Source: Factset
Seven of the eleven sectors within the S&P 500 were up in June. Despite a downturn in the last week, Information Technology led the index with a gain of +7.49%, followed by Communication Services at +3.60% and Consumer Discretionary at +3.57%. Conversely, Utilities experienced the most significant decline, posting a loss of -3.55%, followed by Materials with a decline of -1.63%.
Additionally, the equal-weighted S&P 500 underperformed the benchmark by 9.18% YTD, yielding a return of +5.04% compared to the S&P 500's +14.22%. This underperformance was further emphasised in June, with the equal-weighted version achieving a return of +0.27% compared to the S&P 500's +3.23%.
Source: Factset
An analysis of the past five years (60 months) reveals that the June performance of major US stock indices has generally surpassed the median. Specifically, the June performance of the S&P 500 and Nasdaq 100 ranks at the 62.7th and 67.7th percentile, respectively, indicating that only 22 and 20 months out of the past 60 have witnessed superior performance. Similarly, the Dow Jones Industrial Average's May performance of 1.87% corresponds to its 52.5th percentile. Meanwhile, the Russell 1000's performance, currently at 2.96%, ranks at the 59.3rd percentile, signifying that approximately 24 months out of the past 60 have yielded higher returns.
Europe
Stoxx Europe 600 +0.14% MTD +8.33% YTD
Germany DAX -0.93% MTD +9.40% YTD
FTSE 100 +0.07% MTD +7.09% YTD
France CAC 40 -3.58% MTD +2.17% YTD
Spain IBEX 35 -1.32% MTD +10.59% YTD
MSCI Europe +0.28% MTD +8.42% YTD
Source: Factset
The Stoxx Europe 600 has also displayed a mixed performance in June. The Technology sector has emerged as the frontrunner, +4.00%, followed by Healthcare +3.63% and Retail at +0.59%.
Conversely, the Basic Resources sector was -3.48%, followed by the Oil & Gas sector at -2.71%. This may be attributed to concerns regarding subdued demand.
A comparative analysis of the Stoxx Europe 600 Equal Weight (EW) index reveals a contrasting picture. The EW index, which assigns equal weight to each constituent company, has posted a -1.25% decline in June, underperforming the Stoxx Europe 600's +0.14%, which contrasts with EW index outperformance in May. Moreover, its YTD performance stands at +4.98%, 3.35 percentage points lower than the European benchmark. This suggests that market breath in Europe has narrowed in June, as large-cap companies have outperformed small-caps.
Source: Factset
An analysis of European equity index performance over the past five years (60 months) indicates weaker results compared to their US counterparts in June 2024.
The Stoxx Europe 600's June performance of +0.14% ranks at the 40.6th percentile, signifying that 35 months within this timeframe have yielded higher returns. The Stoxx Europe 600 demonstrated the strongest performance among European indices.
Germany's DAX, the UK's FTSE 100, and MSCI Europe performed above the 30th percentile, at 37.2%, 38.9%, and 38.9% respectively, as of 24th June. This implies that between 47 and 46 of the past 60 months have seen stronger performance than June 2024 for these indices.
Conversely, the CAC 40 exhibited the weakest performance, positioned at the 15.2nd percentile. This signifies that 50 out of the past 60 months have witnessed stronger performance for the CAC 40. The snap election called by President Macron, following the results of the EU Parliamentary elections, has ignited concerns regarding fiscal sustainability within the Eurozone, given the potential for a radical policy shift.
According to LSEG I/B/E/S data, as of 25th June, Q1 2024 earnings are expected to decrease 3.3% from Q1 2023. Excluding the Energy sector, earnings are expected to increase 0.7%. Q1 2024 revenue is expected to decrease 4.6% from Q1 2023. Excluding the Energy sector, revenues are expected to decrease 3.1%. Of the 289 companies in the STOXX 600 that have reported earnings for Q1 2024, 60.6% reported results exceeding analyst estimates. In a typical quarter 54% beat analyst EPS estimates. Of the 345 companies in the STOXX 600 that have reported revenue to date for Q1 2024, 51.3% reported revenue exceeding analyst estimates. In a typical quarter 58% beat analyst revenue estimates.
Financials, at 78%, was the sector with most companies reporting above estimates. Utilities, at 33%, was the sector that beat earnings expectations by the highest surprise factor. In the Real Estate sector only 20% of companies reported above estimates. The Real Exstate sector’s earnings surprise factor was the lowest at -10%. The STOXX 600 surprise factor is 10.4%, which is higher than the 5.8% long-term average (since 2012).
Analysts expect positive earnings growth from 7 of the 15 countries represented in the STOXX 600 index. Portugal (96.6%) and Italy (12.5%) have the highest estimated earnings growth rates, while Poland (-27.8%) and Austria (-26.1%) have the lowest estimated growth.
Points for investor consideration: Should market concentration be a concern for investors?
From 2013 to 2023, the concentration of the US stock market, as measured by the weighting of the top 10 stocks, nearly doubled from 14% to 27%. This signifies a disproportionate influence of a select few stocks on the overall market return. For instance, the Magnificent Seven contributed over half of the S&P 500's 26.3% gain in 2023.
However, a historical analysis of the S&P 500, along with a comparative study of other markets, suggests the current concentration level of the S&P 500 alone does not adequately represent a significant risk indicator.
Historical market concentration
At the end of 2023, the combined market capitalization of the top 10 companies within the S&P 500 constituted 27% of the index's total, nearing the previous peak of 30% observed in 1963. This represents a significant increase from the lowest recorded concentration of 12% in 1993 and 14% as recently as 2014.
A parallel trend is evident in the MSCI All Country World Index, encompassing mid and large-cap stocks across 47 developed and emerging markets, covering approximately 85% of the global investable equity universe. The top 10 constituents of this index accounted for 19% of total capitalization by the end of 2023, more than double the level a decade prior. This concentration intensified further in early 2024, reaching 28% in the US and 20% globally by the end of the first quarter.
According to Morgan Stanley's Counterpoint Global, what may be particularly unsettling for many investors is the unprecedented pace of this concentration increase over the past decade, marking the most rapid escalation since 1950.
Looking beyond the US and at the sector level
Despite the recent surge in concentration, the US equity market remains the fourth most diversified among major global markets. India, Japan, and China exhibit lower levels of concentration, while Switzerland, France, and Australia exceed 40%. A study of 47 equity markets from 1989 to 2011 revealed an average weighting of 48% for the top 10 holdings. Finland and Switzerland experienced concentrations exceeding 80% in 2001, with Nokia alone representing roughly two-thirds of Finland's total market capitalization during its peak in the early 2000s.
Another form of market concentration that has emerged recently is sector-specific, particularly within the technology sector. While more pronounced in the US, this trend is evident in many other markets, especially in Asia.
This relative growth in technology sector dominance is not inherently concerning, as it largely reflects underlying earnings growth. According to Goldman Sachs, the current prominence of the technology sector, even within the US market, is not historically unprecedented compared to other dominant sectors in the past. The Information Technology sector is currently the largest, yet its size is comparable to that of the Energy sector at its peak in the mid-1950s. It remains smaller in the index than both Transportation, which dominated in the 20th century, and Finance and Real Estate, which drove the majority of the equity market in the 19th century.
Do fundamentals support market concentration?
An alternative perspective is to assess whether the underlying fundamentals justify the shift in concentration over time. The question is whether the change in market capitalization of leading companies is underpinned by actual value creation.
Fundamentally, stock market concentration can be viewed as the distribution of value creation. Individual companies experience fluctuations in their value creation prospects throughout their existence, and stock prices reflect expectations of future value creation.
According to Counterpoint Global, during the decade ending in 2023, a period of marked concentration increase, the top 10 stocks constituted an average of 19% of market capitalization, while these companies generated an average of 47% of economic profit, measured as return on invested capital (ROIC) minus the weighted average cost of capital (WACC) multiplied by invested capital. While market expectations may be flawed, it is difficult to argue that the market capitalizations of the largest companies are without some fundamental support.
Furthermore, the divergence between large-cap and small-cap ROICs has widened in recent decades. From 1990 to 1999, the aggregate ROIC for large caps averaged 0.8 percentage points higher than that of small caps. This difference increased to 4.1 percentage points from 2000 to 2023. In 2023, the average ROIC for the top 10 companies was 27.4%, while the aggregate ROIC for the Russell 3000, encompassing most US public companies (excluding financials and real estate), was 10.1%.
The market tends to generate above-average returns during periods of rising concentration and below-average returns when concentration is declining.
Does investing in dominant companies generate lower returns over time?
Survivor bias, the phenomenon where an index is continuously reconstituted as less successful companies are replaced by those with better growth prospects, plays a significant role in market dynamics. The past two decades have witnessed the emergence of a group of companies that have rapidly ascended to dominance in technology and related industries, drastically transforming the business landscape. Among the current top 50 US companies, only half held that position a decade ago, with many not even existing before the 1990s: NVIDIA (1993), Amazon (1994), Netflix (1997), PayPal (1998), Alphabet (1998), Salesforce (1999), Tesla (2003), and Meta (2004).
Due to these shifts in leadership and growth, historical data suggests that investing solely in dominant companies may yield lower returns over time. Goldman Sachs research indicates that while the average total return since 1980 for holding the top 10 stocks over various time horizons (1 to 10 years) is positive in absolute terms, these returns diminish over time. More significantly, when compared to the S&P 500 index, the returns for these dominant companies are generally negative if held for extended periods, as newer, faster-growing companies emerge and outperform them.
However, this does not imply that these companies are inherently poor investments. They may continue to be solid compounders, offering greater stability, lower volatility, and higher risk-adjusted returns compared to their newer counterparts.
How can investors best benefit from current market concentration at the stock level?
In comparing the two prominent stock cohorts, the Magnificent Seven and Europe's GRANOLAS, it becomes evident that the latter presents a more compelling diversification and valuation profile. The GRANOLAS, comprising 11 of the largest companies in the STOXX 600 across sectors such as technology, healthcare, luxury, and consumer staples, offer a diversified growth opportunity. These stocks trade at a lower valuation (approximately 20x P/E) than the Magnificent Seven and have demonstrated strong performance.
Furthermore, the GRANOLAS share several characteristics with the technology leaders: robust balance sheets, high profitability, and similarly high and stable margins. Additionally, akin to healthcare companies and the Magnificent Seven, they exhibit a high reinvestment rate, enabling them to compound earnings over time. GRANOLAS have contributed 86% of the STOXX Europe 600 index returns since January of 2022.
Conclusions
The past decade has experienced a notable increase in stock market concentration, a measure reflecting the proportion of total market capitalization held by a limited number of stocks. This trend has practical implications for active managers, who often construct portfolios with smaller average market capitalizations than their benchmarks and face challenges in generating excess returns during periods of heightened concentration.
Increased concentration also raises concerns regarding the potential loss of adequate diversification, the possibility of overvaluation in the largest stocks, and the potential negative impact of flows into index funds. Quantifying some of these concerns remains challenging.
It is pertinent to question whether current stock market concentration in the US is excessive or if past levels were too low. Even after a decade of increasing concentration, the US stock market remains one of the more diversified globally.
The rise in concentration can be justified by fundamental performance. From 2014 to 2023, the top 10 stocks averaged 19% of market capitalization while generating 47% of total economic profit. In 2023, these figures rose to 27% and 69%, respectively. This demonstrates that the relative market capitalizations of these companies are not without a basis in fundamental economic performance.
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