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Weekly Market Analysis - US Equities – Corporate Profits Already Hitting New Highs
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EPS Gains Broadening in 2024
US equities have struggled a bit to reach new records as large cap tech remains below the recent July peak. Election uncertainties are just ahead. However, EPS gains are broadening with 9 of 11 sectors growing in the year through 2Q. This is a sharp improvement from 2023 when roughly half of S&P 500 constituents posted EPS declines.
Citi’s CIO Raises 2024 & 2025 EPS Estimates
With most of 2Q in hand, we raise our S&P 500 EPS estimates slightly with gains of +9% and +8% expected for 2024/2025 (our previous estimates were for gains of 8% and 6% respectively). We believe these estimates are somewhat conservative, but still require continued economic expansion.
Corporate Profits Expected to Produce New Highs in the Coming Years
There are two-sided risks for EPS in 2025 in particular. 1H EPS results for the S&P 500 were sub-10% despite a few large firms growing rapidly. The impact of AI spending on EPS is uncertain. A wide range of US policies from the new administration and Congress are possible. However, interest rates are falling while the economy is most likely to produce new record highs in corporate profits in coming years.
Summary
As equity markets rebound from a summer swoon, it looks as if checks and balances are beginning to bind markets too. US equities (65% of world market cap) are struggling to recover their July 16 high even as they have rebounded about 8% from their August 5 low. This is with the help of a nearly 50 basis point drop in two-year US Treasury yields as the bond market priced in bolder easing steps from the Fed.
The rally has also come as second quarter 2024 corporate profit levels reached a new record high, with solid visibility towards expanding EPS significantly further.
At the July high, the S&P 500’s year-to-date total return exceeded 20%. This is no small feat after a 26% return in 2023. But this of course was made possible by the 18% loss in 2022. This is where EPS comes into play. Following the bulk of 2Q EPS reports, we are making slight upward revisions to our S&P 500 EPS estimates for both 2024 and 2025 (see chart). We now see S&P 500 EPS rising about 9% in 2024 and 8% in 2025 vs 8% and 6% previously.
Portfolio considerations
Broadening EPS growth and a sharp drop in debt capital costs is cushioning a market with a somewhat high overall valuation (for the S&P 500, 23X this year’s EPS and 20X excluding tech). “Concentration risk” in mega caps has come down since the Magnificent 7 underperformed since early July. Like politics, we see “checks and balances” slowing the broad US equity market ascent. We also see the strongest long-term opportunities outside the S&P 500 or even Nasdaq 100. Small and mid-cap growth shares are relatively inexpensive. What investors may not realize is that EPS growth for profitable, growing small and mid-cap firms has been faster than that of most large caps over the past five years.
Source: FactSet, Bloomberg as of August 29, 2024. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
EPS Gains Broadening in 2024
As is custom in all but the deepest earnings downturns, with the help of analysts, US firms had no problem exceeding estimates when they reported second quarter results this summer. But despite an average beat of over 5%, markets sold off during the busiest two weeks of the earnings season as many firms moderated guidance for the second half of 2024. After significant downward revisions to 3Q, we see the bar as sufficiently lowered to continue the tradition of broad earnings beats next quarter. Consensus estimates for 2025 at 14.4% remain higher than our new estimates, but this is typical when looking at analyst estimates beyond a quarter ahead.
We have been on the “broadening train” all year for two reasons. First, we viewed excessive index concentration as a risk for investors who seek truly diversified exposure to public markets. Indeed, the Magnificent 7 concentration peaked at 31.5% of S&P 500 market cap in mid-July after strong outperformance throughout Q2. We’ve discussed in previous bulletins the perils of portfolio concentration (please see our June 22nd CIO Bulletin).
Second quarter earnings season reminded investors that mega cap tech is not invincible. Ongoing AI-related capex has far outpaced big tech revenues, and after six quarters of significant AI spending ramp-up, some investors are growing impatient about the eventual fruits of this investment. Four of the Magnificent 7 sold off following their 2Q earnings results.
Citi’s CIO Raises 2024 & 2025 EPS Estimates
Following the bulk of 2Q EPS reports, we are making slight upward revisions to our S&P 500 EPS estimates for both 2024 and 2025. We now see S&P 500 EPS rising about 9% in 2024 and 8% in 2025 vs 8% and 6% previously.
The good news? We believe today’s record high EPS levels will be exceeded through coming quarters. The bad news, our estimate increases are modest. The overall pace of EPS gains in 1H (just below 10%) is unusually strong for a period off Fed easing, but not historically rapid.
Corporate Profits Expected to Produce New Highs in the Coming Years
Another driving force for our broadening call was our expectation for a wider range of companies to deliver positive earnings growth in 2024 and 2025, a dynamic which we see playing out in recent results. This has enabled the equal- weight S&P 500 to reach a new all-time high this week even while tech remains off its own peak. While a 10% return in the average S&P 500 stock has not kept pace with tech year-to-date, our overweight has outpaced performance of broad bond indices where we remain underweight (the Bloomberg Barclays Multiverse is up 2.4% YTD).
As we continue to make new highs for profits into 2025, a nascent earnings recovery will also likely be playing out among smaller firms. While small and mid cap companies have seen their profits lag in 2023 and 2024, falling financing costs and a less tech-dependent earnings backdrop should be supportive for SMID profitability next year. Within the profitable SMID universe, firms tend to operate with more debt and higher usage of floating rate bank financing. As the Fed cuts rates through 2025, earnings-after-interest costs for small firms should improve.
