In recent quarters tech stocks have generally outperformed, led by Nvidia with company revenue more than doubling to $30 billion, up 122% year-on-year. Needless to say, excitement regarding AI is partly driving this extraordinary performance. The magnificent seven, a group of stocks that picked up the US market leader baton from the FANGs, now display much stronger expected earnings growth than was anticipated by the broader market.
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Given the market prominence of tech stocks, we might perceive them as responsible for the good S&P 500 performance of late. At around a 27% uptick, the S&P 500 is on track to record another lucrative year-on-year return in August. This return sits at the frontier of the best returns we might anticipate, given the current level of prevailing risk, as reflected by CBOEs’ VIX. However, we could even argue that tech stocks’ equity valuations are not only justified but, as many would argue, still lower than where they could be, given the strong current and prospective earnings. It all depends on whether you view their recent outperformance as a genuine phenomenon or simply a bubble. More broadly speaking, we could ask whether the same is true for the rest of the market?
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Professor Shiller’s excess cyclically-adjusted earnings yield suggests that, on average, equity shares become gradually less attractive as the earnings yield offered loses ground over bond yields. That ratio currently sits at a relatively low 1.1%, the same level from which it fell off a cliff during the dot-com bust of 2000–2001. This does not mean that a repeat of the dot-com period should be expected, however it serves to emphasise that we are possibly reaching a ceiling from where corporate earnings could grow, on average. Upon hitting that ceiling, some price adjustments to lower levels may be necessary to make equities attractive again.
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The potential chance of reaching an inflection point in valuations is also reflected in analyst expectations. With no points below the 45-degree line, the chart below indicates that the valuations of all US sectors are expected to thin in the coming 12 months, according to I/B/E/S analysts. Tech stocks are set to maintain their comfortable lead, but they are also expected to adjust significantly lower in the next year given that they are the furthest from the diagonal. The same applies to health care. For bargain hunters, the cheapest sectors with small, expected valuation adjustments are oil, coal and gas, telecommunications and financials. If the former energy sectors are not so attractive prospects, due to ESG and dated business model considerations, then financials may be a worthwhile alternative to explore.
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Risk-adjusted returns definitely support that option, as it is financials (and not tech stocks) that offer above-market Sharpe ratios — the rate of average daily return over their volatility for the past year. Optimism regarding the resilience of the diversified US banks, following the SVB drama, returned in late 2023, but regional banks only recently started to catch up, with more upside potential ahead should the grass-root economy remain robust.
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To summarise, the magnificent seven still drive the market and this is expected to continue given their strong prospective fundamentals. However, we are reaching the ceiling regarding average corporate earnings growth, which can potentially lead to valuation adjustments and bargain hunting from equity investors. The stocks of financial companies appear to offer good returns, while they are relatively cheap and can therefore accommodate such demand. However, bargain hunters need to remember that financial stocks come with their own unique risks. As we outlined in a recent note (see: https://lipperalpha.refinitiv.com/2024/03/news-in-charts-banks-the-canary-in-the-coal-mine/), financial stocks, like another ‘canary in the coal mine’, would be the first to reflect signs of any sublime economic stress – a feature that any investor seeking a bargain may be averse to.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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