While the anxiety over market valuations continues to grow, fueled further by concerns regarding Trump’s economic agenda, the economy remains thoroughly robust. While that is good news, a higher climb means a farther fall, which would validate people’s concerns over the current market highs.
We’ll save our in-depth opinion about Trump’s economic policies for another day. In short: tariffs are inherently inflationary, and our country is ill-suited for another period of high inflation. In addition, Trump’s proposed tax cuts don’t really help the people that are most likely to be burdened by another round of high inflation. There will be lots of tax savings, but mostly for people who don’t need it. Although we can debate the legitimacy and effects of “trickle-down economics,” for better or for worse, immediate tax relief for those who need it most isn’t part of the plan.
Instead of theorizing on what is to come, we should discuss the present. Over the last two years, we have had a robust economy and a soaring stock market. GDP is strong and unemployment is low (only a fraction of one percent higher than “full employment”). We see no immediate threat to the strong market metrics and corporate earnings. The biggest near-term risks we see are inflationary policy and market setbacks caused by unusually high valuations. But we don’t see a slowdown in economic activity.
Before we proceed, we want to thank our good friend Rob Swanke (CFA, CAIA) for his contribution to this weekend’s article. Let’s get into it…
Santa’s Bag of Beats
In the third quarter, we saw 5.9 percent earnings growth exceeding 4.2 percent analysts were expecting when we entered earnings season. The “Magnificent Seven,” which includes Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia, and Tesla, produced nearly all the growth of the S&P 500 with 21 percent growth for the quarter—above the 19 percent that was expected going into earnings season. This result is in spite of the fact that Apple reported earnings of $0.97 per share versus the expectation of $1.60 per share due to a $10.2 billion charge related to the impact of an adverse ruling in Europe regarding tax payments. The rest of the index had a really low bar, with an expected earnings decline of 1 percent that they managed to beat with growth of 1 percent.
Markets rewarded earnings beats, delivering an average price increase of 1.6 percent from the two days before reporting earnings to the two days after, which is above the 5-year average price increase of 1 percent. On the other hand, high valuations contributed to an average price decrease of 3.1 percent when companies missed earnings, which was above the 5-year average decline of 2.3 percent. As we move into 2025, we expect high valuations will continue to place greater importance on not only beating earnings but also delivering solid guidance to continue to see price increases.
The communications sector delivered the biggest gift, with a positive earnings surprise of 11.8 percent. This included a range of companies that beat estimates, including Take-Two Interactive, Fox Corporation, Alphabet, Meta, and Electronic Arts. Consumer discretionary also delivered 10.8 percent earnings beats, with a broad range of companies beating earnings, including Garmin, Nike, Hasbro, Deckers, and Amazon.com. Health care, industrial, and financial sectors rounded out the best performers relative to expectations. The materials and tech sectors received “coal” during the quarter, with the aforementioned Apple weighing heavily on the tech sector.
Source: FactSet Consensus Analyst Estimates, as of 12/6/2024
We entered the quarter waiting to see if the rest of the index outside of the Magnificent Seven could close the earnings growth gap. Still, it was the largest companies that continued to provide the engine for growth in the U.S. During the quarter, analysts lowered estimates for the future in line with historical averages but projected that those companies would continue providing the lion’s share of U.S. growth. Fourth-quarter estimates have the Magnificent Seven seeing 24 percent growth versus the rest of the index at 8 percent. They expect a similar story in 2025, with 21 percent growth for the Magnificent Seven and 13 percent for the rest of the index.
While it may be healthy to see a broadening of growth throughout the economy, given the heavy weight of the Magnificent Seven in the index, the markets will likely rely on growth in those companies in the near future.
Sources: J.P. Morgan Asset Management, FactSet, Standard & Poor’s Guide to the Markets – U.S., as of 12/6/2024
How High Can Expectations Go?
In the midst of a solid earnings season, we also had an election, which helped drive valuations above 22x forward earnings (levels we saw in 1998 and 2020). While both periods saw significant growth in the subsequent years, it is difficult to continue to satisfy high expectations, as we saw in both cases. If earnings continue to surprise to the upside, it could justify the current valuations, but we expect valuations to come down as growth expectations begin to level out.
Given the high growth expectations, we could see valuations come down while prices go up, which could be healthy for the market. Investors should also consider other parts of the market outside of large-cap growth companies. These companies are trading closer to historical averages, and a broadening of the market could benefit them.
Staying in the Present
As we’ve said, the economy is strong, but it’s valuations are lofty by almost every measure. For those of you who have asked if we will bail on the market, the answer is a resounding no, for the same reason we didn’t bail a year ago. (Boy, would that have been a sin!) We will, however, buy into any significant dip if the market loses ground while the economy stays strong. But the conversation would change if the economy doesn’t remain strong. For now, we await the new presidential administration, and we’re eager to see if anyone out there can teach Mr. Trump that tariffs are not paid by the Chinese government, just like a giant wall built by America would never have been paid for by Mexico.
We believe (hope) that once Trump is in office, policy will be built on academic data, not on rhetoric that wins elections. So, we are mildly optimistic that decisions made in January will be more beneficial to us than what was promised during the election cycle.
We wish everyone a wonderful weekend!
-Matthew