The first half of 2024 was very good to U.S. equity investors. The S&P 500 was up 14.5% excluding dividends for that period. As stock market investors look forward to the second half, the first order of business will be the Q2 earnings reports, and there are a number of unanswered questions.
The bulls will argue that forward 12-month EPS estimate revisions have been strong, which should be positive for stock prices. The bears will argue that top-down macro reports have largely missed expectations, which foreshadows a period of earnings disappointment and negative guidance. Moreover, valuations are becoming stretched, which will be a headwind for stock prices.
Who is right? Here is a preview of the Q2 earnings season.
A strong bottom-up outlook
Let’s start with the good news. As we look ahead to Q2 earnings season, FactSet reported that S&P 500 forward 12-month EPS revisions are strongly positive, which is a bullish sign of positive fundamental momentum.
On a bottom-up basis, Street analysts are expecting above-average EPS growth of 11.2% for 2024 and 12.7% for 2025.
A K-shaped recovery
On the other hand, Peter Atwater, author of The Confidence Map, has argued that the U.S. economy is undergoing a K-shaped recovery:
The haves suddenly had much more which, in turn, fostered an extraordinary wealth effect. For luxury in all its forms – fashion, travel, cars, real estate… – the post-COVID economy has been a golden era, sending companies like LVMH to the top of the charts.
Meanwhile, those at the bottom have not only been left behind as financial assets have soared, but with interest rates rising, they have paid a higher and higher price to stay afloat. Since 2021, food prices have risen by more than 20%, automobile loan rates have all but doubled, and today, U.S. banks charge over 25% on most credit card balances.
The net result is that behind a supposedly strong and resilient single U.S. economy, there are two: one where those at the top spend like there is no tomorrow, and one where those at the bottom struggle to make it through today.
The Transcript has documented anecdotal evidence of the K-shaped recovery from earnings calls:
“We’re seeing pretty consistent behavior with the upper-income consumers – they’re continuing to buy as they normally have.” – Casey’s General Stores CEO Darren Rebelez
“I think what we believe that we’re seeing is a little bit of impact on almost like a bifurcated economy. I think most people in this room feel pretty good about the economy, feel pretty good about what’s going on, but I think that…if you’re out there more in a working class at the lower end of the economy, you’re having to make choices every day about how to meet your mortgage, how to pay higher insurance costs, how to keep food on the table in a much higher cost environment… And so, they’re having to make tougher choices” – Phillips 66 CEO Mark Lashier
“…if you’re in the lower end of the income spectrum in the U.S., you’re under pressure from inflation…And you can see that pressure coming through — saw that pressure coming through in QSR restaurants and a number of areas where footfall or basket size was under pressure and, of course, consequent behaviors looking for affordability.” – Coca-Cola CEO James Quincey
Consumer-driven companies have responded by prioritizing a focus on volume growth by lowering prices. McDonald’s has famously brought back its $5 menu, along with a number of its competitors. General Mills revealed during its earnings calls that it’s increasing the practice of couponing in order to pursue volume growth.
From a top-down perspective, the Citigroup Economic Surprise Index (ESI), which measures whether top-down economic releases are beating or missing expectations, has weakened to levels last seen in 2022. This is indicative of a deceleration in the economic growth outlook that stands in direct contradiction to the sunny bottom-up earnings expectations of Street analysts. The silver lining to this dark cloud is that ESI has shown a rough correlation to bond yields, and lower yields would put upward pressure on stock prices.
The anecdotal evidence of lower price pressure is good news on inflation for the Fed. The market is now expecting two quarter-point rate cuts this year, with the first at the September FOMC meeting and the second at the December meeting.
Elevated valuation
Another concern for equity prices is valuation. The S&P 500 is trading at a forward P/E of 21.0, which is above its 5-year average of 19.2 and 10-year average of 17.8. These levels are above historical norms. It’s also a warning for investors who follow the Rule of 20, which stipulates that the stock market is overvalued if the sum of the P/E multiple and inflation rate is above 20.
On the other hand, I found a surprising result from my monthly screen of LBO candidates, (for an explanation of my LBO research see How To Buy A Company If You Have No Money).
In my first publication in late May, I screened non-financials within the S&P 1500 looking for LBO candidates, or stocks an investor could buy with no money down. Last month, I found no stocks fitting that criteria and 22 stocks which you could buy with 30% down.
The latest update of my screen revealed three stocks that an investor could buy with no money down and 25 stocks in total that you could buy with 30% down or less. This is a somewhat surprising result in light of the strong gains exhibited by the S&P 500 in June. I attribute this to the valuation bifurcation between large-cap technology stocks and small- and mid-cap stocks. Evidence of deep value is emerging among SMID cap stocks.
