Difficulty: Moderate
1) The 2Q Earnings Season spices up next week, with 46% of S&P 500’s market capitalization reporting!
2) Market breadth remains low, a cue that has historically preceded large stock market drawdowns.
3) Valuations of the largest five S&P 500 stocks can be justified, only if earnings growth expectations can hold.
The InvestQuest’s View: Don’t be too hasty to buy stocks ahead of next week’s earnings. We will be seeing four of the five largest S&P 500 stocks (Apple, Amazon, Google, Facebook) reporting on 29-30 Jul, and given the narrow market breadth and fairly expensive valuations, we might be due for some profit-taking should management guidance be underwhelming.
1) The 2Q Earnings Season spices up next week, with 46% of S&P 500’s market cap reporting!
2Q Earnings Season has been relatively uneventful so far, despite a -44% year-on-year consensus earnings decline expected from bottom-up estimates. In July, the S&P 500 Index has not had a daily price change of more than 1.6%. The VIX Index (or what some people refer to as the “Fear Index”) continues to grind lower, indicating that investors are getting more comfortable and/or complacent.
This may change next week, as 46% of S&P 500’s market cap reports 2Q earnings. In the chart below, we have listed the % of S&P 500’s market cap reporting results over the next two weeks, with the number of stocks that are reporting each day. After 7 August, earnings announcement risk will be minimal as no more than 2% of the Index market cap will be reporting on any single day.
We have summarized a list of the largest US stocks which will be reporting earnings in the next two weeks (table below). While there are 365 companies in total reporting during this date range, we have only included stocks that have an Index weightage of 0.3% or more within the S&P 500. Stocks that have an Index weightage of 0.5% or more are highlighted in orange. These are the stocks that could potentially move the market:
2) Market breadth remains low, a cue that has historically preceded large stock market drawdowns
Market breadth refers to how broad-based a rally in the stock market has been – has the stock market’s rally been across most companies (wide market breadth) or supported primarily by just a few companies (narrow market breadth)?
Recently, stock markets have rallied on narrow market breadth, which has led to some investor concerns. Year-to-date, S&P 500 is flat, while Nasdaq is up 16%. While this paints a relatively rosy picture, a big concern is that Index returns have been driven by the outperformance of a handful of mega-cap tech stocks, while the the broader economy is still hurting.
Market breadth is near narrowest level in the last 20 years (chart below). The market breadth was computed by comparing the price levels of the S&P 500 Index and the median-performing S&P 500 stock. Specifically, market breadth looks at 1) how far below the S&P 500 Index is currently trading at vs its 52-week high and 2) how far below the median-performing S&P 500 stock is currently trading at vs its 52-week high, and 3) looks at the difference between (1) and (2) in percentage points.
For example, if the median-performing S&P 500 stock is trading 13% below it’s 52-week high, and the S&P 500 Index is trading 5% below it’s 52-week high, the market breadth will be -8 percentage points.
Sharp declines in market breadth in the past have often signaled large market drawdowns. For example, in addition to the Tech Bubble, breadth narrowed ahead of the recessions in 1990 and 2008 and the economic slowdowns of 2011 and 2016.
market concentration carries risks” published 22 July 2020
Another measure of market breadth is to look at how the largest five stocks on the S&P 500 have performed, relative to the Index. The chart below offers some perspective. The largest five S&P 500 stocks (Facebook, Amazon, Apple, Microsoft and Google) have rallied 35% this year, while the other 495 S&P 500 stocks have declined by 5%.
market concentration carries risks” published 22 July 2020
As a result of the outperformance of the largest five S&P 500 stocks, these stocks (Facebook, Amazon, Apple, Microsoft and Google) now comprise 22% of the Index’s market cap (chart below), reaching highest levels on record.
The implication is that it is getting increasingly important to follow what’s happening to these five stocks, four of which are reporting earnings on 29 and 30th July! In the next section, we look to see how justified the current share prices are for these five stocks.
market concentration carries risks” published 22 July 2020
3) Valuations of the largest five S&P 500 stocks can be justified, only if earnings growth expectations can hold
Stock valuations are not cheap in absolute terms but everybody already knows that. Some consolation is that once we strip out the relatively more expensive five largest stocks (Facebook, Amazon, Apple, Microsoft and Google) from the S&P 500, valuations on the remaining 495 stocks are slightly more palatable at 18x P/E (chart below).
market concentration carries risks” published 22 July 2020
The five largest S&P 500 stocks comprise 22% of the Index but only contributes 15% to Index earnings. The last time we saw such a big gap was prior to the Dotcom Bubble sell-off, not providing much room for comfort.
market concentration carries risks” published 22 July 2020
However, we do have to take into account that the five largest S&P 500 stocks (Facebook, Amazon, Apple, Microsoft and Google) do offer a higher earnings growth potential, relative to the other 495 S&P 500 companies.
This is where the PEG ratio comes in. Essentially, think of the PEG ratio as the P/E ratio divided by long-term earnings growth expected. For example, if a stock has a 25x P/E and 10% long-term annual earnings growth expected, the PEG ratio will be 2.5x (25x divided by 10). It is a generally accepted view that buying stocks with a PEG ratio of <1 is desirable.
The chart below shows the PEG ratio of the largest five S&P 500 stocks, compared to the other 495 stocks. Once adjusted for long-term expected earnings growth, it would seem that valuations of the five largest S&P 500 stocks trade fairly relative to the remaining 495 stocks.
market concentration carries risks” published 22 July 2020
While the tone of this article has a bearish tilt (which reflects our view), we acknowledge the fundamental reasons why large cap tech stocks have done particularly well and it’s not just because of the boost in demand for e-commerce, home entertainment and cloud computing this year.
Monetary stimulus such as lower interest rates and money printing has had a drastic impact on driving down market risk premiums, which have inevitably boosted stock and bond prices in the past quarter. This is in stark contrast with the prevailing macro conditions during the Dotcom Bubble (where we made a few comparisons to earlier), when the Fed was actually hiking rates instead!
The InvestQuest’s View
We conclude with two important caveats:
- While the largest five S&P 500 stocks are fairly valued “relative” to the remaining 495 stocks, it could be the case both categories of stocks are still overvalued in absolute terms.
- PEG ratios make use of future earnings growth expectations, so concluding that the largest five S&P 500 stocks are fairly valued “relative” to the remaining 495 stocks will only hold true if actual earnings can keep up with the earnings growth expectations.
The InvestQuest’s View: Don’t be too hasty to buy stocks ahead of next week’s earnings. We will be seeing four of the five largest S&P 500 stocks (Apple, Amazon, Google, Facebook) reporting on 29-30 Jul, and given the narrow market breadth and fairly expensive valuations, we might be due for some profit-taking should management guidance be underwhelming.
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