What Will Replace the Magnificent Seven in 2024?

Disclaimer on valuations

Before I share my analysis, it's worth emphasizing that changes in valuations, often called multiple expansion or contraction, can play an outsized role in the performance of a stock or index. Regardless of changes to earnings, sales, or other fundamental data, investors' desire to buy or sell, if strong enough, can divorce a stock's price from its fundamentals.

For example, last year, the S&P 500 was up 23%. Approximately half of its increase was due to rising earnings, and the other half from increasing valuations.

The graph below shows how P/E multiple and EPS changes contributed to the S&P 500 price change since 2009. In six of the 15 years, the changes in EPS and valuations were opposites of each other. In 2020, a significant increase in valuations more than offset declining earnings. Conversely, in 2021, EPS spiked, and valuations gave up most of its 2020 gains. Even if you forecasted EPS to the penny at the start of those two years, your S&P 500 projection would have been dead wrong!

S&P sector earnings forecasts

S&P Global puts out a wealth of data on the S&P 500, which I use in this analysis. The table below is broken down into the 11 S&P 500 sectors and compared to the entire index.

Given the importance of valuations, as I noted, the first three columns show the current P/E ratio next to the three-year pre-pandemic average and the average of the last two years. This comparison provides context for a valuation on which to base my analysis.

With those three price-to-earnings estimates, we can imply the potential S&P 500 return by estimating earnings per share. S&P Global provides the 2024 EPS estimates for our analysis.

If the P/E remains unchanged, the price return equals the change in earnings. The two columns furthest to the right of the table compute the potential price change if P/E reverts to the pre-pandemic average or the more recent average.

The S&P 500 will gain 13.6% if valuations remain unchanged yet only increase by 2.30% or 7.89% if valuations revert to prior averages.

Will 2024 be the year of the laggards?

The graph below, courtesy of Finviz, highlights the large discrepancy in the returns of the S&P 500 sectors.

The three sectors with the worst performance last year, healthcare, consumer staples, and utilities, offer the best potential returns in 2024, as calculated in the table above.

In my analysis, the energy sector could have a remarkable 168% return if its P/E returns to its pre-pandemic average. But its P/E is volatile as its earnings swing much more than other sectors. Its long-term P/E average is in the mid-teens. If its P/E climbs back to such a level, a 50% increase in share prices is in store, assuming earnings are relatively flat.

After a strong 2023, technology, communications, and consumer discretionary (cyclical) have projections more in line with the market.

Sentiment trumps fundamentals

As I noted earlier, valuations play a significant role in performance. Consequently, it's crucial to appreciate the sentiment and narratives in place. The Magnificent Seven and, to a lesser degree, large-cap technology, communications, and discretionary are in vogue. Valuations are generally expensive in these sectors and are rising. Despite such high valuations, the positive sentiment toward these sectors could continue for part or all next year.

Conversely, the out-of-vogue sectors may continue to underperform. Returning to my article From Magnificent 7 To A New Team, I compared one of the market's hottest stocks in 2023, Nvidia, to an out-of-favor stock, Albemarle. To wit:

To help appreciate what may lie ahead, we compare Nvidia to Albemarle. Nvidia is up 230% year to date. As a result of the stock surge, Nvidia's investors are paying a 250% premium for Nvidia's earnings versus those of the S&P 500. Nvidia's earnings will undoubtedly grow faster than the market for a while, but by how much and for how long? Can they avoid competition and margin pressures while keeping sales elevated long enough to justify the premium?

The world's largest lithium producer is in quite the opposite shoes. Despite strong demand for lithium from electric vehicles (EV) and a projected shortfall of lithium to meet growing EV needs, Albemarle investors only demand a price to earnings of five, about one-fifth of the S&P 500. Its shares are down about 30% year to date.

Despite the significant value in Albemarle compared to Nvidia, investors continue to chase Nvidia and sell Albemarle.

Regardless of valuations, Nvidia and its six other compatriots may continue to lead the market. Albemarle and the many stocks in the out-of-favor sectors proposition may continue to languish.

Summary

The combination of earnings expectations and valuation regression argues that utilities, staples, and healthcare will outperform the market.

But sentiment and changes in investors' perceptions via valuation expansion or contraction can easily dominate returns.

Investor sentiment is challenging to predict but relatively easy to measure. We must be ready to act on our forecast if necessary. But at the same time, we must respect current sentiment and appreciate recent trends. As John Maynard Keynes once said:

The markets can remain irrational longer than you can remain solvent.

Be flexible and respectful of current trends and sentiment but cautious and aware of evolving market conditions.

Michael Lebowitz is a portfolio manager with RIA Advisors and author for Real Investment Advice. For more information contact him at [email protected] or 301.466.1204.

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