Earnings metrics can only tell us so much when viewed in isolation. The FTSE 100 is trading at 12.7 times earnings, roughly half the rate of Nasdaq and well below the 20.7 price/earnings multiple attributable to the S&P 500. There’s also a 3.9 per cent dividend yield to take into the equation, underlining the reason why it’s advisable to gauge the performance of the UK benchmark on a total return basis.
There are many reasons why US stocks are commanding higher multiples, but the ‘risk-off’ sentiment towards the domestic market probably has less to do with earnings projections than it does with the outlook on interest rates. Inflationary pressures have been far more persistent in the UK than they have been across the Atlantic.
Given the worsening geopolitical situation, it may be unwise to make too many assumptions where markets are concerned but it appears that the US Federal Reserve will have some leeway on interest rates long before the Bank of England (BoE). Bond yields continue to ratchet up, elevating the risk-free rate of return, while ensuring that future cash flows get discounted at a higher rate, none of which is favourable for equities.
Rapidly rising bond yields also make it more difficult for central banks to assess whether monetary policy is too tight or too loose. Policymakers at the BoE will be grappling with the need to curb inflation even as economic growth stagnates. There are signs that 14 successive rate rises are now weighing on aggregate demand in the economy and analysis from the EY ITEM Club shows that around 2mn additional households will come to the end of a fixed-term mortgages over the second half of this year and throughout 2024. And it should be remembered that interest rate increases generally have a delayed effect on economic growth.
Commentators have pointed to the disproportionate influence of the drolly named 'Magnificent Seven' on US index multiples. Collectively, Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA) and Meta (META) account for just under a third of the S&P 500 index's entire market capitalisation. They have been the driving force behind the US stock market rebound this year which has been achieved despite rising bond yields and the spectre of recession.
The trouble is that market movements that are precipitated by a handful of stocks can easily run out of steam, whereas broad-based movements are more likely to endure. Nonetheless, recent analysis from the London Stock Exchange indicates that the 'hot money' going into exchange traded funds has been destined for cap-weighted US funds.
It will be interesting to find out whether there was a swing in favour of equal-weighted S&P 500 funds after the yield on 10-year US Treasury notes briefly eclipsed the 5 per cent mark – an event deemed 'psychologically important' by some commentators, although why I don’t know.
More salient is the fact around 40 per cent of the junk bond debt taken on by US companies during the pandemic falls due during 2024-26, according to Bloomberg analysts, so we’re probably going to hear a lot more about refinancing costs going forward.
The S&P 500 is still 11.5 per cent adrift of its high-water mark at the end of 2021, although it has staged a vigorous recovery since the general rotation out of growth stocks through 2022. Yet there is a stark difference between profit forecasts for market-leading tech stocks and the remainder of the S&P 500 index.
Indeed, the average forward price/earnings ratio of the Magnificent Seven at 34 times is nearly double that of the wider index. With a flurry of quarterly earnings updates in prospect, the market may be more inclined to take a more critical line on how rapidly earnings growth is building, especially given the rise in risk-free yields.
It’s generally held that the steep rise in ratings we witnessed during the year is primarily linked to the buzz generated by artificial intelligence (AI), hence Nvidia’s outperformance – up 200 per cent year-to-date. It’s quite conceivable that many of the mega-tech stocks will get a shot in the arm through the roll-out of AI technologies, but the trouble for anyone buying in after multiples have expanded so rapidly is that it could take an age to recoup their investment.
The differential between the earnings expectations for the 10 largest stocks in the S&P 500 and the remaining index constituents hit their apex (43:21) in the lead-up to the collapse of the dotcom bubble. While there was undoubtedly a more speculative element to capital allocations at the end of the 1990s — tantamount to a leap of faith in many cases — it is just possible that late entrants may have already paid over-the-odds for mega-cap tech in 2023.
