When a Cinderella story comes out of nowhere to win a championship, fans are ecstatic (just like I was watching Tom Brady win his first Super Bowl against the heavily favored Rams). But once teams have experienced success, the bar will continue to rise—and teams must also rise to meet the next challenge.
For markets, the first quarter of 2024 was the first challenge, after roaring in 2023 by beating very low expectations. When we entered the reporting season, analysts were calling for earnings growth of 3.4 percent. While still a relatively low number compared to historical averages, it was a step up from flat earnings in 2023.
With 98 percent of the S&P 500 now reporting, 78 percent of those companies have beaten earnings estimates, leading to an expected 5.9 percent earnings growth for the quarter. More importantly, as I discussed in my earnings preview, earnings expectations for the rest of the year remain high, helping to support valuations that remain above 20x forward earnings expectations.
Growth Companies Continue to Outperform
Eight of 11 sectors reported year-over-year earnings growth, with 3 of the top 4 sectors being communication services, tech, and consumer discretionary (the largest sectors within the Russell 1000 Growth Index). Each of these sectors includes at least one of the “Magnificent Seven” (i.e., Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta, and Tesla), which have been driving earnings growth for the index. In fact, without the Magnificent Seven, the S&P 500 would have seen a 2 percent earnings decline. Combined, these seven companies saw earnings growth of 50 percent compared to the first quarter of 2023.
Communication services saw growth of 33.9 percent for the quarter, leading the S&P 500. Alphabet and Meta made up nearly all the growth in this sector, which would have gained only 1.8 percent without those two companies. Similarly, Nvidia made up a majority of the growth within tech, whose 25.2 percent growth would have been only 11.2 percent without Nvidia. Nvidia’s growth was also nearly half of the entire index. Consumer discretionary saw growth of 24.9 percent; without Amazon, it would have been only 2.8 percent.
This trend is expected to continue for the next two quarters: growth of the Magnificent Seven is expected to be 28 percent and 16 percent in the third and fourth quarters, respectively, while the rest of the index is expected to see growth of 5 percent and 6 percent, respectively. Not until the fourth quarter do analysts think that the rest of the index will match the Magnificent Seven with 17 percent year-over-year earnings growth.
Source: FactSet Consensus Analyst Estimates (as of 5/31/2024)
Value Sectors Still Doing Well
Including the top three growth sectors, nearly every sector beat expectations. Health care was the lone exception and was heavily influenced by Bristol Myers Squibb, which took a significant one-time loss related to in-process research and development. Excluding the company from the index would have put the sector in line with the expected decline at the beginning of the quarter.
Within the sectors primarily represented in the Russell 1000 Value Index, utilities had the best quarter. They saw broad-based growth, with significant margin expansion as utilities were able to pass on higher prices to consumers despite seeing the largest decline in revenues during the quarter. Many value sectors performed better than expected but not to the same degree as the growth sectors.
Valuation Will Matter Eventually
With the Magnificent Seven dominating the earnings picture, they rightfully deserve premium valuations, although the appropriate level could certainly be debated. As a whole, the S&P 500 is valued at close to 1.3x its 20-year average, while the Russell 1000 Growth Index is valued at 1.4x. The market punished earnings misses in the first quarter more than average, with a 2.8 percent decrease in price compared to the average 2.3 percent decline.
With these higher valuations and high earnings expectations, meeting or likely exceeding earnings estimates will be important as we move forward this year. Lower valuations for value stocks and small- and mid-cap stocks could give them a bit more cushion should they not live up to earnings expectations.
Dynasty in the Making or One-Hit Wonder?
This quarter certainly cemented the Magnificent Seven as the main driver of earnings. These companies are expected to continue to dominate the earnings picture over the next few quarters. But as we get closer to year-end, their higher valuations will make higher returns and continued outsized growth more difficult. Competitors will continue to look for ways to break into their outsized profits. As a lifelong Patriots fan, I know that dynasties can last a long time but, inevitably, will end—and it’s important to never count out the competition.
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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.
The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.
The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.
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