Slowing earnings growth is removing some of the invincibility surrounding the stock market’s tech giants as they prepare to report earnings this week. Whether they can reverse that trend will largely determine whether the stock rally can continue.
The five largest companies in the S&P 500 index by market capitalization (Apple Inc., Nvidia Corp., Microsoft Corp., Alphabet Inc. and Amazon.com Inc.) are expected to report average earnings growth of 19% in their third-quarter results, according to data compiled by Bloomberg Intelligence. While that would comfortably outpace the S&P 500’s projected 4.3% gain, it would also represent its slowest collective expansion in six quarters, BI data shows.
Furthermore, the gap between Big Tech and the rest of the market is expected to continue to narrow until 2025, when last year’s roughly 35% quarterly earnings growth will be a distant memory. So the question for investors is what this means for these stocks, all of which have soared during the latest market rally, and whether they can continue to lead the indexes higher.
“Sentiment is much shakier than in previous quarters and the factors driving the market now look more negative,” said Andrew Choi, portfolio manager at Parnassus Investments in San Francisco. “That doesn’t mean the rally is over, but there are opportunities elsewhere, especially now that we have these debates about Big Tech valuations, weaker earnings momentum and every story now has some element of controversy or debate weighing on it.” about feeling.”
The market turns
For most of the past two years, tech giants have driven the S&P 500 higher, fueled by relentless earnings expansion and investors willing to continue paying higher multiples for those earnings. However, that has changed in recent months.
Since peaking on July 10 following a 22% rally earlier in the year, the Bloomberg Magnificent 7 index, which includes the five S&P giants, plus Meta Platforms Inc. and Tesla Inc., has fallen one 2%. That lags all major S&P 500 sectors, with utilities, real estate, financials and industrials groups up more than 10% and the broader index gaining 3.1% in the same period.
All of this has put big tech companies in a position they are not used to: they are losers in the stock market. They face increased scrutiny with lofty valuations and questions about when their big investment in AI initiatives will pay off.
“The technology companies’ surrender of their market leadership position could last until the end of the year, but that doesn’t deter us from holding on to them for the long term,” said Ross Mayfield, investment strategist at Baird. “Obviously, there’s a risk that earnings growth is slowing and valuations may be a bit overstated. But they still bring a lot of growth and there is still significant upside potential for earnings in the coming years.”
While Tesla has already posted better-than-expected third-quarter earnings and an encouraging outlook, Big Tech’s earnings season really begins in earnest this week. Google owner Alphabet reports on Tuesday, followed by Microsoft and Meta Platforms on Wednesday, and Apple and Amazon on Thursday. Nvidia is not expected to report results until late November.
A future of AI
All of this week’s reporters have their own problems. Microsoft is facing concerns about its prospects in the artificial intelligence space. Apple has seen early signs of tepid demand for its new iPhones, although long-term optimism helped push shares to a record high last week. Amazon investors are worried about high capital spending eating into profits. And Alphabet has regulatory uncertainty as the US Department of Justice investigates it for monopolistic practices.
AI will be a topic of great interest to investors who pay close attention to earnings reports, particularly how much companies are spending on expensive infrastructure. It is estimated that in the third quarter, Microsoft, Alphabet, Amazon and Meta Platforms will have invested US$56 billion in capital expenditures, 52% more than in the same period of the previous year.
Investors generally accept the premise that companies’ AI investments represent the future of the technology, but there is also little evidence of an immediate increase in profitability for companies like Microsoft, which has integrated AI capabilities into its software products. Disappointment over the disparity between AI spending and results marred an otherwise strong second-quarter earnings season. Now, it’s raising concerns about future profit margins.
“Top-line earnings are starting to be offset by increased AI-related capital spending,” Bloomberg Intelligence strategists Gina Martin Adams and Michael Casper wrote in a research note. “That implies that peak margins are likely to be a thing of the past, at least in the short term.”
Big Tech’s recent underperformance has coincided with deteriorating confidence among Wall Street’s so-called smart investors. Hedge funds have been selling Magnificent Seven shares for the past few months, and despite modest purchases in October, net long positions as a percentage of total U.S. exposure are still at the lowest level since mid-2023, according to data from Goldman Sachs’ prime brokerage desk.
The valuation enigma
Despite the decline in mega-cap stock prices, many of these companies have valuations above historical averages. Apple is trading at 32 times its estimated earnings for the next 12 months, compared to an average of 20 times over the past decade, according to data compiled by Bloomberg. Microsoft trades at 33 times, compared to an average of 25.
“If you look at the technology sector, are earnings really going to grow enough to keep pace with these multiples, or does some of the recent strength reflect a fear of being left behind?” said Clark Bellin, chief investment officer at Bellwether Wealth. “You can’t discount the impact of momentum, but at some point the music could stop and people need to manage their expectations this earnings season.”
To be sure, Wall Street professionals remain overwhelmingly bullish on Big Tech. About 90% of analysts covering Microsoft, Alphabet and Nvidia have buy ratings on the stock, according to data compiled by Bloomberg. The numbers are 83% for Alphabet and 65% for Apple, while the average S&P 500 company sits at around 53%.
The reason for the optimism is quite simple: despite all the concerns, they still offer above-average earnings growth, exposure to artificial intelligence, strong capital returns and less risk than other sectors of the stock market, according to Choi , by Parnassus.
“It’s hard to find dominant companies with this kind of earnings growth,” he said. “There are still a lot of things we like.”
