In terms of earnings, stock performance, and valuation, this continues to be a tale of two markets. The ten largest stocks by market capitalization now account for one-third of the weight in the S&P 500 index, one of the largest concentrations in history. Those 10 stocks contributed 74% of the S&P 500’s return in the first half of the year. That index is up 15% year-to-date, but the Equal Weight S&P 500 is only up 5%, and the Russell 2000 index of smaller capitalization stocks is up less than 2%. Despite the S&P 500 index trading near record highs, the number of new lows exceeds the number of new highs. In the first quarter, five companies posted earnings growth of 64% while the other 495 companies in the S&P 500 reported a 6% decline in earnings. While the S&P 500 index trades at over 21 times forward earnings, the equal weight index trades for 16 times forward earnings.
Over the next several weeks, we will get an update on the economy and corporate profits as we enter the second-quarter reporting season. This quarter’s company earnings reports will be insightful as we track profit margins (currently at near record highs) and the spending patterns and trends of companies making investments in artificial intelligence (AI), as well as those companies selling AI infrastructure. The expectations around revenue growth and productivity from AI are a key driver in today’s valuation of stocks. Consensus expectations are for earnings growth of 9% versus the second quarter of 2023.
On the economic front, inflation has remained sticky with the Fed calling for higher rates for a longer period of time. Fiscal spending is out of control and is financed by increasing federal debt. With higher rates on that debt, this year federal interest expense will exceed both defense spending and Medicare spending. The U.S. consumer has kept the economy growing with strong spending, but much of the excess savings from the pandemic handouts has been exhausted. One positive aspect of higher interest rates is that money market funds are paying $500 billion in interest equaling 2.5% of consumer spending. Geopolitically, half of the world’s population is voting this year with rightward turns in the EU and a leftward turn in Mexico.
As we enter our 37th year of serving clients, we recall many other periods when the macroenvironment looked rather bleak. And yet the stock market has weathered those past crises by continuing to move higher. While today’s higher valuations logically reduce future returns, we remain optimistic about the future earnings potential of corporate America.
Comments