Life's Been Good...for Large Caps

While a stronger relative growth rate for small caps is a positive, it has to be looked at in a broader context. The estimate for 2024 earnings growth has been cut aggressively since last summer—from 33.4% in July 2023 to 20.7% as of Friday. For the S&P 500, cuts to estimates have been less dramatic, from 11.7% to 9.9% over the same timeframe. It's normal to see analysts revise their estimates lower throughout the year. However, that tends to end around the middle of the year, so if estimates are still getting slashed in the back half of 2024, it will be more of a warning sign.

Source: Charles Schwab, LSEG I/B/E/S, as of 4/26/2024.

S&P 500 sectors shown. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance does not guarantee future results.

The real-time cuts to estimates are shown in the chart below. Focusing first on the blue line, which is the estimate for first-quarter earnings growth, analysts were expecting growth of around 14% this time last year. As that expectation has been revised lower significantly, estimates for the rest of the year have mostly trended higher over the past few months. Notably, the consensus estimate for the fourth quarter of this year remains strong at nearly 15%, although it has ticked down.

Earnings optimism for 2024

Source: Charles Schwab, LSEG I/B/E/S, as of 4/26/2024.

S&P 500 sectors shown. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data. Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance does not guarantee future results.

Focusing on what matters

Given that earnings estimates are a perpetually moving target, let's shift focus to what will likely matter more for the market moving forward. Across several metrics, valuations remain stretched. Per Bloomberg data, the S&P 500's forward price-to-earnings (P/E) ratio is 20.3 and its price-to-sales (P/S) ratio is up to 2.7. Both are elevated relative to their long-term averages (going back to 2000) of 16.5 and 1.7, respectively.

Any rally driven more by multiple expansion (growth in the P/E, P/S, or any valuation metric) underscores investors' optimism and, at times, exuberance. Given valuation is a horrible short-term market-timing tool, though, we don't think the current expensive nature of the market means the bull run is at an imminent end. Rather, we think continued strength in earnings growth will help put downward pressure on valuations—but key is whether both the top and bottom lines can hold up.

As shown in the chart below, that is the case so far for first quarter earnings, but not as much for revenues. The "beat rate" (the percentage of companies reporting growth above analysts' estimates) for earnings has ticked up to a healthy 77.7%, which is stronger than the average of 67% (going back to 1994) but slightly worse than the prior four-quarter average of 79%. It's a different (and worse) story for the revenue beat rate, which has fallen to 59.4%. Not only does that compare to a longer-term average (back to 2002) of 62%, but it's the lowest since the first quarter of 2020.

Keep in mind that beat rates don't necessarily correlate with actual growth results. As the revenue beat rate has slid over the past year, revenue growth has continued to improve. However, given the growing gap between earnings and revenue surprises—and the fact that stronger earnings growth has been driven by aggressive cost cutting—we think there will be more focus on the revenue side moving forward.

That could be the reason the market is less excited about companies that outpace analysts' earnings estimates. As shown in the chart below, after reporting earnings, the average S&P 500 member's daily return in excess of the index's return is barely positive at 0.05% so far in this reporting season. That is the weakest return since the fourth quarter of 2020, which, perhaps not coincidently, was the last time the revenue beat rate was as low as it is now.

Market less forgiving

Large and in charge

One of the frustrating aspects of the bull market that started in October 2022 is the lack of strength from small caps. Not only is the S&P 500 outperforming the Russell 2000 by 8% this year, its 42.3% gain since the October 2022 low is much stronger than the Russell 2000's 18.6% gain over the same period, and it's outperforming the Russell 2000 by nearly 10% over the past year (as shown in the chart below).

Small caps, smaller returns

Source: Charles Schwab, Bloomberg, as of 4/26/2024.

Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. Past performance does not guarantee future results.

While it is highly unusual for small caps to lag so much in the early years of a bull market, we think the performance gap can be explained by the trajectory of forward-earnings estimates. As shown in the chart below, forward 12-month estimated earnings for the S&P 500 are well beyond their 2022 high. Conversely, while estimated earnings for the Russell 2000 have moved up over the past year, the growth rate remains far from its 2022 peak. There had been a strong recovery starting in the summer of 2023, but it has since reversed.

Large-cap earnings dominate

We continue to think high-quality small caps can do well throughout the year, but for the overall index to recover meaningfully, interest rate volatility needs to subside and forward earnings growth must reaccelerate.

In sum

Despite a tougher performance backdrop in April, the market still looks quite expensive across a wide variety of metrics. Multiple expansion in and of itself is not a negative for near-term performance, but its key role in driving stocks higher over the past year means the bar is higher for earnings growth. Fortunately, estimates point to a solid year for profits, but we think the market will continue to put an increasing amount of emphasis on revenue growth and forward guidance. We continue to suggest that investors focus on areas that will weather the higher-for-longer rate environment well—namely, companies (or industries) with high interest coverage, strong revenue growth, and strong cash positions (among other high-quality metrics).

About the Authors

Liz Ann Sonders, Managing Director, Chief Investment Strategist

Liz Ann Sonders has a range of investment strategy responsibilities, from market and economic analysis to investor education, all focused on the individual investor.

A keynote speaker at numerous company and industry conferences, Liz Ann is regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron's, and the Financial Times, and she appears as a regular guest on CNBC, Bloomberg, CNN, CBS News, Yahoo! Finance, and Fox Business News programs. Liz Ann has been named "Best Market Strategist" by Kiplinger's Personal Finance and one of SmartMoney magazine's "Power 30." Barron's has named her to its "100 Most Influential Women in Finance" every year since the list's inception, and Investment Advisor has included her on the "IA 25," its list of the 25 most important people in and around the financial advisory profession. Liz Ann has also been named to Forbes' 50 Over 50.

In 1999, Liz Ann joined U.S. Trust—which was acquired by Schwab in 2000—as a managing director and member of its Investment Policy Committee. Previously, Liz Ann was a managing director and senior portfolio manager at Avatar Associates, an original division of the Zweig/Avatar Group. She holds an MBA in Finance from the Gabelli School of Business at Fordham University and a B.A. in Economics and Political Science from the University of Delaware.

Kevin Gordon, Director, Senior Investment Strategist

Kevin Gordon serves as the research associate for Schwab's Chief Investment Strategist Liz Ann Sonders. In addition to providing analysis on the U.S. economy and stock market for Schwab's clients, he helps develop deep-dive projects as well as content for Schwab's public website, internal business partners, and social media outlets. Kevin is a frequent guest on CNBC, Yahoo! Finance, Bloomberg TV, and CBS News, and has been quoted in The New York Times, Forbes, MarketWatch, CNN, The Wall Street Journal, and Bloomberg.

Prior to joining Schwab in 2019, Kevin gained experience in asset allocation research at an investment advisory firm, and worked for a U.S. senator in Washington, D.C. He graduated magna cum laude from Pepperdine University, where he co-managed a student-run investment fund and co-authored academic publications on politics and the economy. Kevin is currently an MBA candidate at New York University's Stern School of Business. He holds a B.A. in Economics and Political Science from Pepperdine University.

Kevin is a member of the President’s Advisory Council for Almost Home Kids affiliated with Ann & Robert H. Lurie Children's Hospital of Chicago

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Performance may be affected by risks associated with non-diversification, including investments in specific countries or sectors. Additional risks may also include, but are not limited to, investments in foreign securities, especially emerging markets, real estate investment trusts (REITs), fixed income and small capitalization securities. Each individual investor should consider these risks carefully before investing in a particular security or strategy.

All corporate names and market data shown above are for illustrative purposes only and are not a recommendation, offer to sell, or a solicitation of an offer to buy any security. Supporting documentation for any claims or statistical information is available upon request.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Small cap investments are subject to greater volatility than those in other asset categories.

Source: Bloomberg Index Services Limited. BLOOMBERG^® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). Bloomberg or Bloomberg's licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg's licensors approves or endorses this material or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

Indexes are unmanaged, do not incur management fees, costs, and expenses, and cannot be invested in directly. For additional information, please see schwab.com/indexdefinitions.

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