The S&P 500 has chugged along to record highs even though just a tiny fraction of the companies in the index have been reporting steady earnings growth. That dependence on a few star stocks might finally be about to change.
“Given the high correlation between Tech’s outperformance in stocks vs. earnings, we expect the narrowing growth differential to be the catalyst for the market to broaden out,” the BofA strategists wrote in a report.
The second-quarter profit increase shouldn’t be a one-time occurrence, either. The BofA strategists noted that an uptick in layoffs outside the tech sector “suggests that there is more cost cutting to be had,” which implies gains in margins for the Other 493 both this year and in 2025.
With a few exceptions—stocks such as
Broadcom
,
and
—investors have been mostly ignoring the Other 493. But both those standouts and the Magnificent Seven are megacap stocks, meaning that broader group is behind most of the gains in the S&P 500 this year. The index, which is weighted according to market capitalization, is up 17% this year, while the
exchange-traded fund is only up 5.8%.
Advertisement – Scroll to Continue
But it looks like the tides could be shifting. The equal-weighted ETF rose more than 1% Thursday following a benign inflation report, while investors took money out of tech stocks. The market-weighted S&P 500 tumbled 1% as a result. The tech-laden Nasdaq fell more than 2%.
The performance gap between the equal-weighted S&P 500 and the broader index could narrow further if more non-tech companies start reporting solid earnings growth, especially because the companies outside the Magnificent Seven trade at more reasonable valuations.
“The silver lining of this massive underperformance is that valuations for most S&P 500 constituents now look pretty cheap relative to the index itself,” said Doug Ramsey, chief investment officer and portfolio manager with The Leuthold Group, in a report.
Advertisement – Scroll to Continue
The equal-weighted S&P 500 ETF trades for a little more than 17 times the per-share earnings its component companies are expected to produce this year. That is below its historical average of about 19 and a significant discount to the multiple of 23 for the S&P 500.
Another encouraging, if counterintuitive, data point is that Wall Street is growing more bearish about second-quarter earnings, analysts at Bespoke Investment Group pointed out in a recent report. There has been an uptick in both companies lowering their financial guidance and analysts cutting their forecasts for earnings.
Expectations are lower, so it may be easier for companies to surprise to the upside. “More often than not, when the analyst expectations bar is set low for earnings season…the S&P 500 rallies,” the Bespoke analysts wrote. “Conversely, when the bar is set high heading into earnings season…the market’s performance has been more uneven.”
Advertisement – Scroll to Continue
So where should investors be looking for earnings growth? According to estimates from FactSet, eight of the market’s 11 sectors are expected to post year-over-year earnings growth. Healthcare and energy are likely to post double-digit increases.
But so are two other familiar areas: information technology and communication services, home to most of the Magnificent Seven. Investors shouldn’t abandon those areas, even if a wider range of stocks make gains.
“There is a case for some excitement around earnings, but the macro trends haven’t changed that much. There is no paradigm shift in what is leading markets,” said Cayla Seder, multi-asset macro strategist with
in an interview with Barron’s.
Advertisement – Scroll to Continue
“Tech has higher profit margins,” she said. “Large-cap quality growth is still the most appealing and attractive space in equities.”
In other words, the Magnificent Seven will continue to dominate even if the Other 493 do better. Cue the famous line from “Once in a Lifetime” by Talking Heads: Same as it ever was.
Write to Paul R. La Monica at paul.lamonica@barrons.com
