Capital Markets Update #34
The headline going into this third quarter earnings season is to expect approximately 30% YoY earnings growth amongst S&P 500 companies. An extraordinary headline, in normal course. According to Factset, the trailing 5-year average earnings beat is close to 7.5% (i.e. above expectations), which would impute 37.5% earnings growth YoY. Furthermore, the trailing four-quarter percent of stocks in the S&P 500 which have beat earnings estimates is hovering around 82%, which outperforms the trailing 5-year average of 78% stocks outperforming estimates. All told, short of the S&P 493 tanking guidance just to beat estimates, it’s hard to say that actual operating “outperformance” isn’t pervasive across the market’s industry segments or various business models. Suffice it to say, the consensus view going into earnings supports what will amount to be a market awash in good numbers…famous last words, we know.
Regarding the ebullient earnings expectations, there’s no real way to paint this in a bad light. We hear all the time “there’s weakness in the economy.” Well, earnings are real. Market value gyrations around inflated equity multiples are a problem, no doubt. But earnings represent receipts from at-the-market transactions. So, all things equal, we’d rather have equity market expansion via huge reported earnings growth than a massive re-rating in forward price multiples like we did in the late 1990’s. Back to the narrative that things are weaker than they appear. Perhaps; but, transaction activity is generally indicative of economic health and, at present, we have a lot of it. We highlighted broad retail sales gains in last week’s note. Of course, if the Anthropic and OpenAI IPO efforts blow up or reveal an emperor without real revenue, that’s a problem. If CoreWeave debt trades further into distress or a few NeoClouds blow up, that’s a big problem as well. Taken collectively, fissures in the AI theme will likely lead to a short-term, broad-based risk-off move until the market digests a new AI growth profile. However, we’re not sure a slowdown in the AI story destroys the US economy. More to come on that next week. Our main point here is to reinforce the fact that underpinning activity remains pretty strong. There are worrying signals, no doubt, but when are there not? We’d rather have strong earnings than weak earnings.
What we wanted to focus on this week is market breadth. Breadth can be evaluated two ways: first, equity flows to various industry segments and second, operating performance across these same industry segments. It’s easy to say market performance is concentrated when evaluating equity flows. Many view market cap concentration as tantamount to helium blowing unabated into a balloon. Ultimately the balloon pops. Bianco Research notes 41 AI-related stocks account for 49% of the S&P 500 market cap. This represents concentration amongst a single theme only second to the railroad boom in the late 1800’s and exceeding 41% concentration amongst TMT equities in 2000 or the late 1990’s Japanese market bubble.
For this piece, we’re more interested in the dispersion of operating performance across the broader S&P 493. Here are a few rough operating stats pulled from “real economy” industry segments within the index. Note, we’re using Yardeni data here. The most logical Yardeni-reported metric to track, for our purposes here, is profit margins. Yardeni only reports historical earnings on a per-share basis which won’t work – share buybacks distort the comps. So, we used profit margins. In theory, if you’re operating from a position of strength in a vibrant market, profit margins remain stable or expand. Within the Consumer Discretionary category, companies are operating at a ~10.5% profit margin, up from ~8% consistently pre-covid. Consumer Staples companies are operating at a 7.0% profit margin, below 7.5% in 2019 but above 6.5% - 7.0% levels from 2012 - 2018. Energy is exploding to the upside, not comparable to historicals. Financials are interesting. Forwards earnings estimates call for approximately 9% earnings growth, down from 13% - 16% in 2025 / 2026. It appears to us that ~9% - 10% earnings growth is comparable to historic levels but we can’t find conclusive data here. Either way, we’re not worried about big banks. Industrials companies are expecting forward profit margins of around 12%, up from 10.5% margins 2019 and well above historical pre-covid levels of 9% - 10%. Materials are showing 13% profit margins, above 10% margins 2019 and well above pre-covid levels of 8% - 10%. All historical ranges do not take into account a handful of outlier outperforming or underperforming quarters and therefore suggest mean or mode performance.
In addition to the above broad categorizations, we find the following helpful. Automotive manufacturer profit margins are extremely stable and despite gapping from 5% in 2012 – 2019 (literally, every year) to 7.5% in 2023, margins have moderated back around 5.5%. Home improvement retail profit margins have fallen from historic highs in 2022 of 10.5% down to 8.5% today. Current home improvement profit margins are at or just below 2019 levels around 8.5% - 9.0%. Consumer Staples Personal Products profit margins of 10.5% are up compared to both 2019 levels of 8.5% and pre-covid levels of 6% - 8%. Profit margins for Construction Machinery and Heavy Trucks companies are up to about 14%, well above pre-covid levels of 8% - 11%.
We fully acknowledge that none of this data is conclusive, but the takeaway we gather is two-fold. First, market-cap concentration is not a terrible thing if the market is genuinely pushing cash towards performing companies. Why wouldn’t we buy a fortress balance sheet like Meta or Google or Microsoft which have 30%+ growth rates and 50%+ profit margins, hundreds of billions on balance sheet and an investment grade credit rating? Why would we instead buy a REIT or consumer discretionary company, or even an industrials company solving to mid- to high-single digits growth rates and significantly less equity momentum? That’s not to say, however, that these “real economy” companies are performing poorly. Which leads us to our second point. Most of the S&P 493, according to earnings and profit-margin data, are running excellent businesses producing real earnings growth and excellent comps. Nike notwithstanding. However, market participants can choose to buy whichever stock they want. From that point of view, market cap concentration is a study on the relative desirability of risk – not always an indictment of an under-performing stock’s business model or its contribution value to the “real economy.” Practically, on a day-to-day basis, we need consumer discretionary, materials, staples, industrials and healthcare companies as much if not more than we do information technology or chip manufacturing companies. Today, chips have higher margins and are experiencing their market-demand moment, so they catch the marginal bid.
Thankfully, according to what we’ve gathered herein, the S&P 493 remains healthy and profitable. This is good news and must be considered as we harp on market concentration. In today’s market, if you want to pull money out of CoreWeave or Nvidia, you can put it in Eli Lilly, Walmart, Apple, Procter & Gamble, etc. and still be exposed to a high-performing, well-run business. If not, buy a 2-year treasury at 4.75% or lock it in for 10-years at 5.10%.