To The Moon

Earnings Season Set to Give Big Tech a Reality Check Amid Valuation Pressures

As we approach mid-July, all eyes are on the Q2 earnings season, particularly for big tech companies. Investors are keenly aware that the performance of tech giants such as $NVIDIA Corp(NVDA)$   , $Microsoft(MSFT)$   , $Meta Platforms, Inc.(META)$   , $Alphabet(GOOG)$   , and $Amazon.com(AMZN)$   will be pivotal, as their stock valuations have reached stratospheric levels in recent months. The upcoming earnings reports will not only shed light on the companies' financial health but also test investor confidence amidst a backdrop of slowing sales growth and high expectations.

According to FactSet, the estimated year-over-year earnings growth rate for the S&P 500 in Q2 2024 stands at 8.8%. This figure, if achieved, will mark the highest year-over-year earnings growth rate reported by the index since Q1 2022. It also marks a slight decline from the 9.0% projected at the end of March, with seven sectors expected to report lower earnings due to downward revisions. Communication service, info tech, energy and consumer discretionary were expected to post better earnings.

Goldman Sachs' Perspective on Big Tech Valuations

Goldman Sachs equity strategist David Kostin highlights a crucial challenge for mega-cap tech stocks: their lofty valuations amid decelerating profit growth.

Through the end of the year, sales growth for megacap equities connected to artificial intelligence is anticipated to have slowed in Q2. Consensus estimates indicate that Amazon, Nvidia, Microsoft, Meta, and Alphabet will face a decrease in profit margins and a halt in sales growth.

"Despite the expected deceleration in mega-cap tech profit growth, the stocks’ valuations generally remain high," Kostin added. "Although the expected slowdown in sales growth sets a low bar for the group’s results, EV/sales valuation multiples have increased by 28% YTD."

"If consensus estimates are realized, the 2Q reporting season will be an important test of whether investors are willing to pay the same valuation premium for the group while the EPS growth differential between the mega-caps and the rest of the market is forecast to narrow significantly in 2H 2024 and 2025," he said.

Kostin points out the asymmetric downside risk faced by growth stocks with high valuations. Historical data over the past 15 years shows that while an equal share of growth stocks either beat or missed consensus forward 12-month revenue growth forecasts, the outcomes were skewed against highly valued firms.

Stocks that beat forecasts outperformed peers by a median of 10 percentage points, while those that missed estimates lagged by a median of 18 percentage points. For companies trading above 8x EV/sales, the underperformance was even more pronounced, trailing the median Russell 3000 stock by 32 percentage points when sales estimates were missed, almost double the typical underperformance of lower multiple stocks.

The five mega-cap tech stocks trade at 8x EV/sales, compared with 3x for the median S&P 500 stock.

"There is a clear disconnect in the huge run-up in U.S. equity valuations and the business cycle," $JPMorgan(JPM.US)$'s Marko Kolanovic wrote, adding that the $S&P 500 Index(.SPX.US)$'s 15 percent year-to-date gain isn't justified, given waning growth projections. "There is a risk that an opposite of the hopeful expectation could play out in coming quarters where growth decelerates, inflation remains firm, and long-term rates don't move sharply lower."

He acknowledged that he "underappreciated the resiliency" of megacap tech companies in terms of price momentum and earnings growth. But he warned that the degree of crowding into those stocks and the concentration of market leadership are at "multi-decade extremes."

Pullback Risks as Buyback Period Ends

Adding to the potential volatility, Deutsche Bank strategists have raised concerns about the impending buyback blackout period. By the end of next week, nearly half of the S&P 500 constituents will enter this blackout period, restricting companies from repurchasing their shares until after their earnings reports. Historically, these blackout periods have led to short-term pullbacks, as was seen in April when the S&P 500 experienced a slight retreat.

Deutsche Bank's Parag Thatte and Binky Chadha note that the tech sector, which has been a significant driver of the market rally, is particularly vulnerable. With discretionary buybacks set to diminish temporarily, the strategists caution that the market might face another period of "breathing," potentially exacerbating the impact of any earnings disappointments.

Optimistic Investor Sentiment

The latest Bank of America Global Fund Manager Survey reveals a shift in investor sentiment, with bullishness reaching its highest level since November 2021. Fund managers are notably more optimistic about the economic outlook, with a significant majority dismissing the likelihood of a recession. This buoyancy has driven cash levels to a three-year low and increased equity allocations, particularly towards US stocks.

However, while the overall market sentiment is positive, concerns about inflation, geopolitical risks, and the upcoming US election remain. The survey indicates a preference for more defensive sectors, with technology stocks seeing reduced overweight positions.

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