With the S&P 500 on track to reach record highs even though very few of the companies in the index are reporting steady profit growth, its reliance on a few star stocks may finally be changing.
“Given the high correlation between tech outperformance and earnings, we expect a narrowing growth gap to be a catalyst for market expansion,” Bank of America strategists wrote in the report.
The second-quarter profit increase also shouldn’t be a one-off: Rising layoffs outside of tech “suggest room for further cost cutting,” Bank of America strategists wrote, implying higher profit margins for the other 493 companies both this year and in 2025.
With a few exceptions, stocks such as Eli Lilly
,
Broadcom
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JPMorgan Chase
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Investors have largely ignored the other 493 companies, including Walmart Inc. and Netflix Inc. But those standouts and the Magnificent Seven are both megacap stocks, meaning this group has driven most of the gains in the S&P 500 this year. The market-cap-weighted index is up 17% this year,
Invesco S&P 500 Equal Share
Exchange-traded funds rose just 5.8%.
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But the tide appears to be turning. On Thursday, a mild inflation report pushed equal-weight ETFs up more than 1%, but investors pulled money out of tech stocks. As a result, the market-cap-weighted S&P 500 fell 1%. The tech-heavy Nasdaq fell more than 2%.
As more non-tech companies start reporting robust earnings growth, the performance gap between the equal-weighted S&P 500 and the broader index could narrow further, especially as companies outside the “Magnificent Seven” trade at more reasonable valuations.
“The bright side of this significant underperformance is that valuations of the majority of S&P 500 stocks appear to be significantly cheaper relative to the index itself,” Doug Ramsey, chief investment officer and portfolio manager at Leuthold Group, said in the report.
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The equal-weighted S&P 500 ETF is trading at just over 17 times its constituents’ expected earnings per share this year, below its historical average of about 19 times and significantly cheaper than the S&P 500’s 23 times.
Another encouraging data point, and perhaps counterintuitive, is that Wall Street is becoming more pessimistic about second-quarter earnings, analysts at Bespoke Investment Group noted in a recent report, with companies increasingly lowering their financial guidance and analysts increasingly lowering their profit estimates.
Low expectations may make it easier for companies to beat expectations. “When the bar for analyst expectations is set low heading into earnings season, the S&P 500 often rallies,” Bespoke analysts wrote. “Conversely, when the bar is set high heading into earnings season, market performance is more uneven.”
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So where should investors expect revenue growth? Eight of the market’s 11 sectors are expected to post year-over-year revenue growth, according to FactSet estimates. Healthcare and energy are likely to post double-digit increases.
But so do two other familiar sectors — information technology and communications services, which include most of the Magnificent Seven — and investors shouldn’t abandon those sectors even as the broader group makes gains.
“While some excitement is expected around earnings reports, the macro trends haven’t changed much. There’s no paradigm shift driving the market,” said Kayla Seder, multi-asset macro strategist at State Street Global Markets.
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In an interview Barons.
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“Tech stocks are profitable,” she says. “Large-cap, high-quality growth stocks remain the most attractive and desirable sector of equities.”
In other words, even if the other 493 perform better, the Magnificent Seven will continue to rule. Remember the famous lyric from Talking Heads’ “Once in a Lifetime”: “It’s the same as it ever was.”
Write to Paul R. La Monica at paul.lamonica@barrons.com
