The S&P 500 index has risen 16% this year driven by 7 mega-caps stocks which are up 60%. The index is up 21% from its October lows and now trades on a P/E of 22x, which compares with a P/E ratio of 31x for the top 7mega-caps in the index.
The U.S. market performance has been mainly driven by positive sentiment
We think there are four main reason contributing to this:
- Rising optimism about an economic “soft-landing”.
- Expectations of a sharp recovery in earnings in the second half of the calendar year.
- Increased confidence that inflation will fall back to the Fed’s 2% target which will inevitably result in policy 22rates declining.
- Strong momentum in the AI and cost cutting narrative for mega-cap tech and consumer stocks.
The U.S. market performance has been mainly driven by positive sentiment
As we enter second quarter earnings reporting season in the U.S. it is worth reconsidering consensusexpectations [Figure 1]. Bottom-up earnings forecasts assume a V-shaped recovery commencing in the secondhalf of the year and then growing at a rate of 13% annualised growth in 2024.
Given these increased levels of earnings expectations, the S&P 500 P/E ratio has risen from its October 2022lows 16x to 21x today, while the dividend yield is only 1.5%. However, the fundamentals – as measured by the profitability of all U.S. non-financial corporates – tells a different story [Figure 2].
U.S. corporate profits had essentially been flat for a decade from 2012 onwards, but then profits doubled duringthe pandemic years as the Federal Government handed out massive stimulus cheques. Now, those profits aredeclining as high inflation and sharply rising interest rates are lowering demand and slowing economic activity.Declining U.S. consumption and sticky high wage growth are combining to push profit margins and corporateprofits lower. We believe the ability for companies to offset falling volumes with higher prices will prove elusivefor all but the highest quality companies.
Buyer beware and remember fundamentals always prevail
Today, consensus investors are betting that the mega-cap tech stocks will be immune from a slowing economy and declining consumption, and that they will be major beneficiaries of the recovery cycle. In addition, these investors are of the view that inflation and interest rates will fall while expecting a “soft-landing” and robust recovery. It seems implausible that we can have both robust growth and low inflation in today’s environment of onshoring (shifting supply to domestic sources), wage pressures and volatile commodity and energy prices.
High U.S. stock valuations and growth expectations leave little room for earnings or interest rate disappointments. We have been in an era of magical thinking where investors believed that mailing cheques to people would not lead to inflation; then when inflation arrived that it would be transitory; that rapidly risinginterest rates will have very little effect on economic activity and corporate profits; and finally that inflation and interest rates will fall back to prior decade lows thereby justifying lofty P/E ratios and double-digit earnings growth. This is a risky cocktail of beliefs. Caveat Emptor!