Anyone past a certain age knows how much easier it was to do things when they were younger. You could stay up all night to finish a project, play a pickup basketball game without stretching, and eat or drink whatever you wanted without many consequences. As we get older, though, we start to see the effects of our poor decisions but also gain the experience that can help guide us.
When we look at the Q3 earnings season, the Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla) have been driving much of the S&P 500’s growth since 2022. As these companies get larger and more mature, maintaining huge growth rates will become more difficult, especially considering the valuations they’re trading at. But size and scale can help them continue to generate outsized profits.
The investment cycle into artificial intelligence (AI) has driven much of the recent earnings gains. At some point, the companies spending on AI will need a return to justify continued investment, and they may be able to close the profit gap. That gap is still expected to be stark in the third quarter, as seen in the chart below. Even since the second-quarter earnings review I wrote last month, growth estimates have been widening between the Magnificent Seven and the rest of the index for the third and fourth quarters.
With valuations for the top 10 stocks by market capitalization in the S&P 500 at 30.5x forward earnings estimates, missing growth targets could hurt significantly. This is nearly 1.5x the average valuation for the top 10 holdings in the index going back to 1996. Valuations for the rest of the index are at 18.3x forward earnings estimates, which is much closer to long-term averages. For the third quarter, as it was for the past few quarters, it is likely to still be the top names driving performance for the index. Still, we’re getting closer to an expected broadening of the market.
Hidden Value or Value Trap for the Rest of the Index?
Tech is expected to lead all sectors, with 15 percent earnings growth during the third quarter. Nvidia is expected to contribute almost half of that growth. Tech makes up 32 percent of the S&P 500 and 49 percent of the Russell 1000 Growth Index. Tech’s 28.6x forward earnings multiple is also the highest among sectors, well above the 18.1x 20-year average.
Health care has the second-highest expectation at 10.9 percent. Pharmaceuticals and biotech are expected to drive much of the growth. Pfizer, Eli Lilly, and Moderna are the largest individual contributors. Without them, the health care sector would see a 7 percent earnings decline. Health care is a mixed picture, with companies in both value and growth. Pfizer is a significant holding in the Russell Value index, and Eli Lilly has seen significant growth from its popular GLP-1 drugs. Energy is expected to be the largest laggard, with a nearly 21 percent earnings decline expected, with a 7 percent weight in the value index and almost nothing in growth. Lower oil prices have contributed heavily to the decline. As it stands now, growth sectors appear appropriately priced for their better prospects.
Is This Quarter the Inflection Point?
The first quarter had a successful earnings season, as companies beat earnings and maintained high expectations. The second quarter was more of a mixed bag, with firms beating expectations but seeing future growth expectations fall. This left the third quarter with lowered expectations of only 4.2 percent earnings growth. Still, future expectations remain high, with expectations for 14.6 percent year-over-year growth in the fourth quarter and 14.9 percent growth for the full year in 2025.
2025 earnings are expected to be generated by a broad range of sectors. Health care, tech, materials, communication services, and industrials all are expecting growth of more than 15 percent. If these numbers come to fruition, it could close the gap between the Magnificent Seven and the rest of the index. While traditional value sectors like financials still lag, the gap is closing. The third quarter may still see growth outperform value, but the rest of the index is looking to compete for capital.
Keep Your Eye on the Ball
There may be volatility ahead with next month’s election. But it’s important not to lose sight of what companies are telling us during earnings season. We may be moving through an inflection point where the upstarts try to take on the established players.
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Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.
The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.
The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.
One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.
The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.
The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.
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