Slowing earnings growth is removing some of the strength surrounding the tech giants in the stock market as they prepare to report their earnings this week. Whether they can reverse this trend will go a long way in determining whether the rally in stocks can continue.
The five largest companies in the S&P 500 by market capitalization — Apple Inc., Nvidia Corp., Microsoft Corp., Alphabet Inc. and Amazon.com Inc. — are expected to do well. – Average profit growth of 19% in the third quarter. The results, according to data compiled by Bloomberg Intelligence. While this would easily exceed the S&P 500’s expected 4.3% increase, it would also represent the slowest collective expansion in six quarters, BI data show.
Moreover, the gap between Big Tech companies and the rest of the market is expected to continue narrowing through 2025, by which time last year’s nearly 35% quarterly earnings growth will be a distant memory. So the question for investors is what this means for these stocks, which all rose during the recent market rally, and whether they can continue to lead the indices higher.
“Sentiment is shakier than in past quarters, and the factors driving the market now look more negative,” said Andrew Choi, a portfolio manager at Parnassus Investments in San Francisco. “That doesn’t mean the rally is over, but there are opportunities elsewhere, especially since we have these discussions around Big Tech valuations, slow earnings momentum, and every story now has some element of controversy or debate that is impacting sentiment.”
The market is spinning
For most of the past two years, tech giants have led the S&P 500 higher, driven by relentlessly rising earnings and investors willing to keep paying higher multiples for those earnings. But this has changed in recent months.
Since peaking on July 10 after a 22% surge at the start of the year, the Bloomberg Magnificent 7 Index, which consists of the Standard & Poor’s Big Five plus Meta Platforms Inc., has fallen. and Tesla Inc., 2%. That lags behind every major sector in the S&P 500, with utilities, real estate, financials and industrials sectors jumping more than 10% and the broader index rising 3.1% over the same period.
All of this has put big tech companies in a position they’re not accustomed to: underdogs in the stock market. They face greater scrutiny as valuations rise and questions about when their big spending on AI initiatives will pay off.
“Technology’s ceding of its market leadership position could continue through the end of the year, but that doesn’t scare us away from owning it for the long term,” said Ross Mayfield, investment strategist at Baird. “Slowing earnings growth is obviously a risk, and valuations may be a little stretched. But they still bring a lot of growth to the table, and there is still a significant upside in earnings potential over the coming years.”
While Tesla actually recorded better results than expected Third quarter earnings With encouraging expectations, the earnings season for major technology companies begins in earnest this week. Google owner Alphabet will report on Tuesday, followed by Microsoft and Meta Platforms on Wednesday, and Apple and Amazon on Thursday. Nvidia is not expected to give results until late November.
The future of artificial intelligence
This week’s reporters all bring their own issues. Microsoft faces concerns about its prospects in artificial intelligence. Apple saw early signs of tepid demand for its latest iPhone, though long-term optimism helped lift the stock to a record high last week. Amazon investors are concerned about heavy capital spending impacting earnings. Alphabet is suffering from regulatory uncertainty as the US Department of Justice investigates it for monopolistic practices.
AI will be a big focus for investors monitoring earnings reports, especially how much companies spend on expensive infrastructure. In the third quarter, Microsoft, Alphabet, Amazon, and MetaPlatforms are expected to pump $56 billion in capital expenditures, up 52% from the same period last year.
Investors generally buy the premise that corporate investments in AI represent the future of technology. But there is also little evidence of an immediate explosion in profitability for companies like Microsoft, which has integrated AI features into its software products. Disappointment with the disparity between AI spending and results It was marred Strong earnings season in the second quarter. Now, this raises concerns about future profit margins.
“The big gains are starting to be offset by higher AI-related capital spending,” Jenna Martin Adams and Michael Kasper, strategists at Bloomberg Intelligence, wrote in a research note. “This means that the peak of profit margins is likely to be in the past, at least in the near term.”
The recent poor performance of Big Tech companies has coincided with deteriorating sentiment due to the so-called smart money on Wall Street. Hedge funds have been selling Magnificent Seven shares over the past few months, and despite modest buying in October, net long positions as a percentage of total U.S. exposure remain around the lowest level since mid-2023, according to data from the prime brokerage desk in Goldman Sachs Bank. .
Evaluation puzzle
Despite the massive stock price decline, many of these companies carry valuations above historical averages. Apple shares are trading at 32 times earnings over the next 12 months, compared to an average of 20 times over the past decade, according to data compiled by Bloomberg. Microsoft was priced at 33 times, compared to an average of 25.
“If you look at technology, will earnings actually grow enough to keep up with these multiples, or does some of the recent strength reflect a fear of missing out?” “You can’t rule out a momentum effect, but at some point the music can stop, and people need to keep their expectations in check this earnings season,” said Clark Bellin, chief investment officer at Bellwether Wealth.
To be sure, Wall Street pros remain overwhelmingly bullish on big tech companies. Nearly 90% of analysts covering Microsoft, Alphabet and Nvidia have buy ratings on the shares, according to data compiled by Bloomberg. The numbers are 83% for Alphabet and 65% for Apple, while the average for the S&P 500 company is about 53%.
The reason for optimism is fairly simple. For all the concerns, it continues to offer above-average earnings growth, exposure to artificial intelligence, strong capital returns and lower risk than other stock market sectors, according to Parnassus’ Choi.
“It’s hard to find dominant companies with that kind of earnings growth,” he said. “There’s still a lot to like.”