Thought of the day

The S&P 500 index fell 2.5% last week and is now in “correction” territory, having fallen by just over 10% since the July highs. Over the last two weeks the index has fallen by almost 5%, its sharpest decline in 10 months.

But the fall in equities at the index level has occurred despite encouraging trends in corporate earnings. Last week was the busiest of the US third-quarter earnings season—about 40% of the S&P 500 market cap reported, including four of the "Magnificent 7" companies (Alphabet, Amazon, Meta, and Microsoft). About 50% of companies' results are now in the books.

  • Earnings are set to return to growth. The percentage of companies beating earnings estimates is in line with historical averages (around 73%), and earnings are beating forecasts, in aggregate, by nearly 8%. We continue to expect S&P 500 EPS growth of 3–4% in the third quarter. Our 2023 and 2024 S&P 500 earnings per share estimates are USD 220 (0% year-over-year growth) and USD 240 (9% y/y growth), respectively. We think USD 240 for 2024 is reasonable, considering that 2023 numbers would be closer to USD 230 if not for the drag from the energy sector and a sharp decline in COVID vaccine sales.
  • Rebalancing explains some of the disappointment in share prices. Reaction to mega-cap growth results was mixed—Alphabet and Meta traded lower the following day, while Amazon and Microsoft traded higher. Part of the underperformance is likely explained by investors re-balancing their portfolios. For example, communication services has been the second-best performing sector (behind energy) since the S&P 500 peaked in late July this year. Positioning likely became stretched, so unless results blew away expectations, investors may have taken the opportunity to adjust their exposure.
  • Forward guidance is in line with historical norms. Expectations for US fourth-quarter earnings per share have been revised lower, by a little over 2%, but around half of that decline is due to one-off non-recurring items, including lower COVID vaccine sales and lower production at the automakers due to the UAW strike. When this is taken into account, downward revisions to expectations for next quarter earnings are in line with the historical average.

So, on balance we think other factors than corporate earnings explain last week’s equity decline. At a macro level, the yield on 10-year US Treasuries has been hovering close to 5% and higher bond yields have been challenging equity valuations. Third-quarter US GDP data came in stronger than expectations, but core personal consumption expenditures inflation data was in line with consensus. Fears the Fed might have more work to do are likely weighing on investor sentiment. Finally, our base case is that a broader escalation of the Israel-Hamas war will be avoided, but rising concerns have pressured stocks.

Positioning and "de-grossing" by leveraged investors (likely due to the pickup in volatility) also appear to have been big drivers with strong year-to-date performers being sold, while weak year-to-date performers were being bid up. This pattern is in line with our recommendation to focus on equity laggards. US equity valuations are becoming increasingly attractive, in our view, with the market trading at 17 times 12-month forward earnings and 15 times excluding the Magnificent 7. We maintain our June 2024 and December 2024 S&P 500 price targets of 4,500 and 4,700, respectively.