Q4 Earnings Recap: US Large-Cap Earnings Justify Their Current Valuation

From a revenue perspective, sales were +1.1% higher than analysts expected, with only Materials and Utilities coming in below expectations. We continue to favor Energy and Industrials over Materials. Utilities is less of a surprise, as we have yet to see enthusiasm surrounding nuclear energy’s resurgence translate to improved fundamentals for the sector.

For the S&P 500 overall, future expectations remained largely stable in response to positive earnings surprises. We would say this is positive overall, with Chart 1 (above) pointing to how strong earnings have been since early in 2023.

Finally, the annualized trend of US large-cap earnings continues to be a positive +7.7% overall, supported by revenue growth of +4.7%. Important to our thesis, earnings for ‘growth’ sectors (Technology, Communication Services and Discretionary) are maintaining strong top line and bottom-line results, and some ‘value’-oriented and defensive sectors (Financials, REITs, Utilities) have benefitted from the interest rate relief the Fed has provided since June. The cyclical sectors (Energy, Materials and Industrials) have not participated in this growth, which is something we will be watching in the quarters ahead.

On balance, a positive trend growth rate, coupled with the updated analysts’ views of growth into 2024 and 2025, provides an overall ‘healthy’ diagnosis for US large-cap stocks, in our view. Given the positive backdrop, we are vigilant in searching for signs of weakness that the analyst community is seeing, that might challenge our view that earnings growth will be long lived. So far, there is little indication of any real challenges.

Lots of Good News this Quarter

The table above summarizes the earnings picture for four different market segments. Relative to the US large-cap - which has a clear growth/technology bias – US small-caps, Europe and Japan all have a greater weighting in the more value-oriented sectors. In the table, the “+” and “-“ signs indicate how things have changed since the previous quarter. We are struck by the improvement of small-caps and, to a lesser extent Japan…whereas Europe is a mixed bag.

While this general improvement could be halted by an assortment of market risk factors including recession, inflation, and political uncertainty, the table generally aligns with our base case of a ‘reflationary’ environment – i.e., that inflation stays contained and the momentum of economic activity is able to persist. This suggests that keeping an eye on inflation and Fed policy is particularly important for us. We think the Fed is on hold, watching for clear evidence that the deceleration in inflation has not stalled. We think inflation will remain closer to current levels than the Fed’s 2% target and thus see rate cuts as unlikely anytime soon.

Beyond Large Cap: Other “Value-Led” Market Segments Improving

• US small-cap: Since rates rose in 2022, the combination of small-cap’s shorter debt maturity and higher debt levels relative to large-cap has resulted in more margin compression. However, we view potential for improvement in earnings going forward. The Fed cut rates last year and we think this contributed to the positive earnings data we are beginning to see in small caps. The Fed has said interest rates are above their ‘neutral’ rate and thus the potential for further rate cuts could materialize eventually, which can unlock more earnings potential in our view. However, since the rate picture remains murky in the near-term, and small cap investments are more volatile, we have not added them in our more risk-averse portfolios.
• Europe: Europe faces two opposing forces: on one hand, the concentration of value-oriented companies in Europe means they should do well in a reflationary environment. To this point, European markets, led by financials, have been strong so far this year. On the other, the political tone from the Trump administration and other geopolitical factors create uncertainty for European businesses and investors. If we can get some positive resolutions from the political side, we would hope to see positive estimates and surprises to begin to create a positive trend in Euro earnings and revenue. We view this trend change as pivotal for us to make a larger allocation to Europe.
• Japan: From an earnings perspective, Japanese companies continue to produce strong results. However, Japan faces a challenge that is distinctly macro in nature. Japan’s poor demographics and import dependence makes stimulating their economy difficult without spurring on inflation. So, while earnings at a corporate level do matter for Japan, they are partially fueled by a weaker yen. This creates a relatively narrow set of macro environment outcomes that are favorable for the country and prevents it from enjoying the valuation multiple expansion that might be otherwise warranted.

Conclusion: Still Favoring US Large-Cap Stocks; Too Early to Gauge Trump and Fed Policy Impact

In our portfolios, we continue to favor stocks over bonds… and there is little in our earnings analysis above to challenge that position. We believe our focus from here shifts to two key areas: emerging policy impact and security selection. From a policy standpoint, the proposals currently on the table regarding US trade and defense policy have the potential to upset the current balance if enacted. However, there is also a strong possibility that most of more radical policies are negotiating tactics and may prove less tenable in execution (see recent Weekly View on this topic). We think the biggest risk to our view is that fiscal policy volatility causes spillovers to inflation, or elevated uncertainty causes corporate spending to slow down. We don’t see the evidence of this as of yet, but we are still in the early days of the new Administration’s policies.

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Originally published at RiverFront Investment Group

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Standard & Poor’s (S&P) 500 Index measures the performance of 500 large cap stocks, which together represent about 80% of the total US equities market.

S&P 600 is a benchmark index for small-cap stocks. To be listed on the S&P 600, stocks must have a market cap of $850 million to $3.6 billion, preventing overlap with S&P's larger cap indices.

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