Most would agree this has been a rather unique year so far. The TSX is making new all-time highs. At the same time, both earnings and economic growth forecasts keep coming down.
The TSX isn’t just up – it’s up nicely at almost 9% as we near the halfway point. It isn’t abnormal for the top 10 contributors to make up over half the gains of this index that contains 223 companies, but the mix is odd, with five gold companies, two financials, one consumer, one technology and one energy.
The S&P is even more odd. Up only 4.2%, the index has become very concentrated given the market caps of the Mag7, which carry a 31% weight in the index. This isn’t anything new, but the divergence sure is. Microsoft, NVIDIA, and Meta are the three biggest contributors to the S&P so far this year, adding +2.8%. But Apple, Tesla and Alphabet are the biggest detractors, subtracting -2.4%. Clearly, we have a bifurcation of the Mag 7.
There is a clear distinction between the Mag7 winners and losers: earnings growth. The average earnings growth over the next 12 months is +19% for NVIDIA, Microsoft & Meta, the positive index contributors. The average earnings growth for the laggards, such as Apple, Tesla and Alphabet, is -5%. High valuations are not necessarily a headwind for stock performance, unless those earnings start to wobble. Then it’s a big problem.
Q2 Earnings Season Is Critical
In a few weeks, earnings season for the second quarter will kick off, and while every earnings season is important, this one may be even more critical. After the recent market rally, and with indices making new highs, valuations are rather elevated. The S&P 500 has peaked out at around 22x a few times over the past five years. And while the TSX has seen valuations as high as 18x over the past decade, it certainly isn’t cheap anymore.
The challenge is that valuations are elevated at the same time that earnings growth is slowing. We would be more comfortable with a 22x multiple for the S&P 500 if earnings were still growing at 12%. But at 7%, we believe that’s precarious. The same issue applies to Canada, but to a lesser extent.
There are some optimistic factors, though. The bar may be set reasonably low for Q2 earnings after all these negative revisions, and there are some signs the revisions have slowed or even turned a bit positive in the past couple of weeks. The U.S. dollar is also lower, which is generally positive for U.S. S&P 500 earnings, given the decent percentage of sales/operations overseas.
The headwind is well known: Mr. Uncertainty. The extended period of volatility around tariffs has certainly reduced the confidence of company leaders in the outlook. During Q1 earnings season, the trend was for companies to pull guidance as they just didn’t know what would happen. Still, without clarity, will we see more companies pull guidance, or are they going to start reducing guidance? That is likely a more important factor in this upcoming earnings season than the number of companies that exceed estimates.
The valuations, or market multiple, are certainly elevated, but they’re influenced by many factors other than earnings growth. Bond yields have come down over the past few weeks, which has helped the multiple expand. Investor sentiment has improved from overly bearish to more of a neutral mood. The geopolitical headlines certainly impact the multiple, and most of this news flow has been market-friendly of late.
The challenge is that these positive levers have already been pulled. To help this market keep going, we would likely need to see a re-acceleration of earnings growth to maintain or improve the current multiple. That may be a big ask.
Final Thoughts
Will the months of uncertainty, which are starting to show up in some pockets of economic data, also show up in earnings this season? Maybe, but the stock-moving factor will likely be the tone and guidance from company leadership. And given valuations are already at the upper echelon, stumbles may prove painful.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L.P.
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