Finally, Earnings Return to Growth

Q2 earnings announcements finished in late August, and we are now well into Q3. The headline story concerning Q2 earnings is that the S&P 500 had positive earnings growth (year-over-year). This includes the non-tech sector, which hadn’t seen earnings growth in over a year. Earnings grew by 11% for the S&P 500 as a whole from Q2 of 2023, compared to 9% growth in Q1 earnings. This is the highest earnings growth we have experienced since Q4 2021 and is a strong indication of the current trend in corporate performance.

As usual, earnings growth was strongest in the tech sector which grew earnings by 31%. The dominant industry was semiconductors and led by Nvidia, which grew earnings by 168%. Interestingly, the next largest source of the earnings growth in the S&P 500 was the utilities sector, with electric utilities leading the way, producing 26% earnings growth. Of course, the main reason that power generation utilities are doing so well is because the data center segment of the tech sector is increasing its demand for energy dramatically. Without the tech sector, S&P 500 earnings grew 2%, which was the first positive growth in non-tech earnings in over a year.

Revenues for the S&P 500 index in Q2 grew by 5.3% year-over-year. This is fastest growth since Q4 of 2022 and represents an acceleration of the 4.7% revenue growth from the previous quarter. Earnings growth continued to be much higher than revenue growth due to a combination of financial and operating leverage. Tech led the way with 13.8% revenue growth, with the semiconductor industry at the head of the pack (27% year-over-year growth). Non-tech revenues grew by 1%.

Profit margins, the ratio of earnings to revenues, increased as well, with the tech sector and financials leading the way. Tech profit margins were 28.6% (vs 25.4% in the previous year’s quarter). The profit margin for financials was 18.7% (vs. 16.6%) and all non-tech had profit margins of 5%. Profit margins for the S&P 500 as a whole were 12.3% vs. 11.6% in the prior year’s quarter.

The basic message from Q2 earnings, which was a replay from previous quarters’ earnings, is that the tech sector’s stock market out-performance appears to be consistent with the sector’s top-line and bottom-line results.

The return to earnings growth for the overall market naturally leads to a question about valuation. Most Wall Street analysts have been extremely worried about the stock valuation of companies relative to their earnings, corporate price-to-earnings (P/E) ratios, particularly in the tech sector. A look at historical P/E ratios (in Figure 1) shows that the P/E ratio for the S&P 500 is at a relatively high level compared to the prior 90 years. The average P/E prior to 1986 was about 13. However, P/E ratios have been growing steadily since 1986. The average post-1986 P/E has been about 20, and the P/E currently is at 23. If P/E ratios were to return to long-run historical averages (in the range of 15 to 18), it would necessitate a decrease of about 30% in the S&P 500’s equity valuation. This is where the concern of Wall Street analysts comes from.

Figure 1 — S&P 500 P/E Ratio (Source: Macrotrends)

To claim that the market is overvalued or undervalued by historical P/E ratios, one needs the average P/E ratio of the market to be mean-reverting, i.e., for there to be an unconditional average around which the market’s P/E ratio moves. So, when the market’s P/E ratio is high, the market will in time revert downward to this unconditional average. Or when the market’s P/E ratio is low, the market will in time revert upward to this unconditional average. There are many simplifying assumptions needed for this mean-reverting model of the market’s P/E ratio to work. One of these important assumptions is for there to be no major structural changes to the economy and firms’ operations through time.

Figure 2 has a graph of corporate profit margins. What is immediately noticeable is that there appears to be a substantial change in corporate profitability that began in the mid-1980s; profit margins were volatile prior to 1986, and they bounced around an average of 5.6%. However, beginning in 1986, the average around which profit margins moved has been trending linearly upward. The average has increased by 75% and is currently at 9.8%.

Figure 2 — Corporate Profit Margin (Source: GuruFocus and Bureau of Economic Analysis)

2nd Quarter earnings provide a glimpse into the explanation for the trend in the corporate margin since the mid-80s — the tech sector. The tech sector rose from being a small part of the US economy prior to the mid-80s to the major driving force of the economy today. Essentially, the broad advancement of technology, beginning with the personal computer in the late 1980s to the current dominant themes of cloud computing, automation, and AI, has driven the tech sector from about 4% of the S&P 500 to 42% today.¹ As a result the tech sector’s revenues, earnings, and profit margins have been driving the S&P 500’s aggregate revenue, earnings, and profit margin growth for the last 40 years. Furthermore, the products that the tech sector introduced over the last 40 years into all other sectors caused a substantial increase in productivity in those sectors and thereby increased their profit margins as well.

So, around 1986, there was a structural break in the US economy: the emergence and growth of the tech sector. And due to this structural break, it is not appropriate to compare P/E ratios (or many other financial metrics for that matter) from pre-1986 to today’s levels. Pre-1986, the P/E ratio averaged about 13. Post-1986, the average P/E ratio has been advancing steadily to its current level, about 23, and will likely continue to advance. But given the structural break that occurred in the 1980s, comparing today’s P/E ratio to those of the 1970s and earlier makes little sense.

Footnotes

[1] Throughout this article, we have been using a non-standard definition of the tech sector. The widely used definition of the tech sector does not include companies such as Amazon and Tesla (classified as Consumer Discretionary), Alphabet and Meta (classified as Communication Services), Uber (classified as Industrial), and many other tech companies. We are re-classifying these firms, correctly, to be in the tech sector.