You Won’t Believe How “The Magnificent Seven” Got Even More Epic! | Financial Times

Good morning. Just as Japan appears to be escaping deflation, China could fall into it. Consumer prices in China were asleep in June, reflecting (among other issues) oversupply and lack of consumer confidence. Remember when China’s buying was on the upswing an easy swap? Email us: robert.armstrong@ft.com AND ethan.wu@ft.com.

What will happen to the magnificent seven?

The earnings that matter most this second-quarter earnings season will be those of the Magnificent Seven: Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla. That’s because (as we’ve been reminded every day for months now) these companies are doing pretty much all the work to keep the US market growing. If their shares tumble in the second half, a good year for the stock market could quickly turn into a bad one. So it’s worth thinking about setting up reports, which will come out in the next month or so.

In early June we noticed that, financially speaking, big tech is a heterogeneous group. We summarized the point like this (we didn’t include Tesla then):

Alphabet, Amazon, Apple, and Microsoft are all seeing valuation increases. Nvidia is undergoing a rapid reassessment of its near-term earnings outlook. Meta is a bit of both.

It is worth revisiting and expanding on this point. In the table below, you can see the fantastic year-to-date returns for stocks, as well as a breakdown of those returns between higher earnings estimates and rising valuations. Note two things in particular. First, outside of Meta and Tesla, what we’ve seen is pure valuation expansion. Second, company valuations fall into three categories: valued in line with the broader market (Alphabet and Meta), expensive (Apple and Microsoft), and incredibly expensive (Amazon, Nvidia and Tesla); although P/E ratios do not has ever been a great metric for Amazon, which is handled with cold indifference to profit). Data from Bloomberg:

Let us now consider, in the following table, the growth expectations for the coming year. Revenue growth bar is high for Nvidia and Tesla. The others are expected to grow in the single digits. Earnings growth expectations, on the other hand, are everywhere. Meta’s expectations of much higher profits, driven by margin widening, are particularly striking:

Are these realistic expectations? For the most part they are consistent with the trend we have seen in the group of seven. Revenue growth has slowed as the pandemic heyday has slipped into the rearview mirror:

Overall, how is the configuration of these crucial titles? Performance was scorching, driven primarily by higher valuations. Revenue growth expectations are broadly reasonable. The background, however, is challenging. This is an exalted bunch – the chatter about AI, especially but not exclusively around Nvidia, has been intense. Equally important, valuations of tech stocks have long been justified by reference to low long-term interest rates. But now long-term rates are rising. The fact that the argument linking valuations and rates was riddled with holes might not matter if people still believe it. In short, these are great companies, but the positioning is rather unappealing.

The most attractive, from a purely financial point of view, are Microsoft and Alphabet. Alphabet has grown less than the others, has a reasonable valuation and expectations are not too high. Microsoft is a little more expensive, but has the advantage that it sells primarily to corporate customers, who should keep investing even if the consumer retires (just look in the line chart above at its slow but steady performance over the last few years). Compare that to, say, Alphabet’s more cyclical advertising machine or Apple’s consumer-driven business.

We are very eager to hear readers’ opinions on which of the Magnificent Seven will perform better over the rest of the year. Email them to us.

The other 493

If stock analysts are to be believed, this earnings season is as bad as it is for corporate profits.

Bottom-up estimates for the second quarter expect stable revenues and earnings contraction of 6-8% year-over-year as high input costs weigh on earnings per share. Then it’s straight back to expansion in the third quarter when the S&P 500 is expected to return to (lack of) growth. According to consensus estimates, by next year, the woes related to the recession will be long over. Earnings are expected to grow 12% in 2024.

The second-quarter contraction reflects acute pain in some sectors rather than a broad-based crisis. The energy industry is emerging from the soaring oil price. Materials companies are facing a sharp decline in sales due to slowing global growth. Healthcare is grappling with high input costs (it’s the pickleball plague!). But in many industries, the earnings look OK:

You’ll note above the impressive earnings expansion in consumer discretionary companies, thanks in part to resilient growth. Nor is it all just Amazon and Tesla (see previous piece). In a note yesterday, Strategas’ Ryan Grabinski rounded up the companies that saw the biggest improvement in second-quarter expectations over the past three months. Travel is a constant theme: Royal Caribbean, Delta, American Airlines, and two casinos (MGM and Las Vegas Sands) are all in the top 10. Business Travel AND Backwards.

Even in the S&P 500, analysts have become more cheerful (ie less negative) about earnings. An increase in the breadth of the earnings revision — the number of analysts raising earnings estimates minus those lowering them — has provided support to the stock rally, notes Morgan Stanley’s Mike Wilson. He argues, however, that the S&P has exceeded what a better breadth of revision can justify (note the divergence in Wilson’s chart below):

The fact that earnings expectations are not particularly high, while the economy continues to surprise everyone with good news, gives us some comfort on the second quarter results. Looking further afield, though, things look a little precarious. Yes, the growth is holding up, but the rate is going up, us have to take, they haven’t bitten completely yet. And steady growth is not the same as a renewed acceleration in growth, which is what is needed for rosy 2024 earnings estimates to hold true. The fact that equity gains this year have come almost entirely from multiple expansion suggests that the good news must keep coming if the market continues to rally. This earnings season, look for companies that provide mediocre (but not necessarily terrible) guidance. If these stocks are brutalized, it’s a sign that expectations have been set too high and the months ahead could be challenging. (Ethan Wu)

A good read

The secret to making good market calls is not to make too many, writes Howard Marks. As they say in baseball: wait for the big pitches.