Falling Out of Love with Earnings Beats

November 1, 2023

By Ellen Hazen, CFA®, Chief Market Strategist

October Takeaways:

  • Third-quarter 2023 GDP of 4.9% was well ahead of economists’ expectations of 3.6%. Inflation remained steady at 3.7% as measured by the Consumer Price Index (CPI). The Personal Consumption Expenditures Index – another measure of inflation – declined by just a tenth of a percentage point, to 3.7%. Both measures are above the Federal Reserve’s 2% target and thus we can expect monetary policy to continue to be restrictive.
  • Jobs again strong. New non-farm payrolls for the month of September (reported in early October) of 336,000 were stronger than expected, and reinforce evidence of a stronger economy and again, justify tighter monetary policy.
  • Bond yields rose. While the short end of the yield curve remained stable, longer-dated Treasury bond yields increased during October. The 10-Year Treasury yield increased by 36 basis points, from 4.57% to 4.93%, continuing the “bear steepener” trade where long rates increase more than short rates. Credit spreads widened by 10-20 basis points during the month, reflecting modestly increased caution on the part of bond investors.
  • Equities breadth remained elusive. The S&P 500 declined by 2.1% in October, continuing September’s slide. Once again, diversification away from US large-capitalization equities did not benefit returns: the S&P MidCap 400 Index declined by 5.3% in the month, while the S&P SmallCap 600 Index declined by 5.7% in the month. International stocks also underperformed the US, with the MSCI EAFE Index declining by 4.1%.
  • The “Magnificent Seven” stocks underperformed with the broader large-cap universe. Those seven stocks (Microsoft, Apple, Alphabet, Amazon, Meta, Tesla, and Nvidia) declined by an average of 2.8%, more than the 2.1% decline of the S&P500. This continues the trend from September, when they underperformed the S&P500 by 0.60%. Year-to-date though, they remain dominant, returning an average of 81%, compared to the overall S&P500 return of 11%.
  • Ozempic the new AI? As the bloom has come off the rose of the AI stocks—those companies creating or benefiting from the rise in artificial intelligence—the latest dynamic in the equity market is the relative underperformance of companies that may suffer from widespread adoption of the weight-loss drug Ozempic. Novo Nordisk, which manufactures Ozempic, appreciated by over 6% in October, while companies that sell snacks (e.g., Pepsi) and companies that provide dialysis (e.g., Davita) have underperformed.
  • Earnings season. Half of the S&P 500 companies have reported Q3 2023 earnings so far. Although the average company has reported higher-than-expected revenue (by 0.3%) and earnings (by 0.9%), these positive surprises are smaller than they’ve been in recent quarters. Moreover, the stock market’s response to both positive and negative surprises has been more negative than in recent quarters, reflecting increased caution by investors. 
  • Workers’ strikes slowly getting resolved. Last month, Hollywood’s writers resolved their strike, but the actors are still in talks. Meanwhile, as of this writing, GM appears to have settled with the United Auto Workers, following recent agreements on the part of both Ford and Stellantis.
  • The Republican Party replaced the Speaker of the House. After removing Kevin McCarthy in early October, the Republican Party elected Michael Johnson as its new Speaker. The current authorization to avoid a government shutdown runs through mid-November; one of his first priorities will be to address government funding.


What We Are Watching in November

  • Fed meeting Oct 31/Nov 1. Chair Jerome Powell has suggested the Federal Reserve (“Fed”) will not increase rates at this meeting, and the market currently agrees. In the background, the Fed continues to reduce the size of its balance sheet, which is down to $7.9 trillion from a peak of just under $9.0 trillion.
  • GDP for Q4 currently estimated at 2.3%, less than half of Q3’s 4.9%. Looking farther out, GDP for 2024 is currently forecasted at 1%, a sharp deceleration from 2023 expectations of 2.2%. That said, 2024 estimates have been increasing for the past several months, in response to stronger than expected economic data.
  • Most of the remaining S&P 500 companies will report earnings during November. We will be watching to see how companies’ 2024 earnings guidance lines up with consensus estimates.
  • October jobs will be reported November 3. Non-farm payrolls have been decelerating for several months but have remained surprisingly resilient. Current expectations are for an additional 180,000 jobs to have been created in October.


A Closer Look at Small Caps


If the outperformance of large-capitalization growth stocks compared to the rest of the market is beginning to moderate, as we have seen over the past two months, does it make sense to take a look at smaller-capitalization stocks?  Closer examination reveals that despite apparent cheap valuations, small-cap stocks may not warrant an overweight position at this point.

For most of the last couple of decades, small-cap stocks traded at a premium to large-cap stocks. For example, between 2000-2021, small-cap stocks traded multiple points higher than large-cap stocks on a forward price-to-earnings basis, with an average 3-point premium. This was generally because during this period, smaller companies had faster earnings growth. As a result, from 2000-2010, the S&P SmallCap 600 Index returned 6 percentage points higher annually than its large-cap sibling. From 2010-2020, small-caps performed roughly in-line with large-caps as this premium valuation compressed.

Since early 2021, small-cap stocks have traded at a two-to-five point price-to-earnings discount to large-cap stocks. Why?

One reason is that small-cap stocks tend to outperform early in an economic cycle and underperform late in the cycle. Since the yield curve inverted in the middle of 2022, investors have been concerned that we are in a late-cycle period and have consequently exhibited less interest in small-caps.

Another reason is that—unlike in the 2000s—small-caps have much higher debt levels than large-caps. For example, during the 2000s, average small-cap net debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) was a full 2 points lower than that of large-caps. However, starting in about 2011, that flipped. Today, the S&P SmallCap 600 Index has higher debt-to-EBITDA by nearly 3 points. Moreover, small companies are significantly more exposed to higher interest rates – about one-third of their debt is floating-rate or near-term maturities, as opposed to less than 20% for large-cap companies.

Possibly because of globalization, the margin gap between large-cap companies and small-cap companies has widened in recent years. Large companies have always been more profitable than small companies, but this gap has widened from about 6 points higher EBITDA margin to about 9 points.

Much of this can be explained by the different sector composition of the large-cap index vs. the small-cap index. You can see from the table that the small-cap index has a much higher weighting in Financials, which generally carry both lower multiples and higher debt. Similarly, it has a much lower weighting in Technology. This is a fairly recent development and may explain the change in price-to-earnings dynamics: ten years ago, when the S&P 600 traded at a premium, the sector weightings were very similar to one another. Thus, looking at today’s aggregate valuations as compared to history masks the changes in underlying composition that have occurred over the past decade.

One other item to note: There is more than one small-cap index, and they are not all created equal. The S&P 600 has a higher-quality composition than the Russell 2000 Index. For example, more than 37% of Russell 2000 Index companies are currently unprofitable; this is only true of 26% of the S&P 600. Similarly, Russell 2000 Index companies are more indebted than S&P 600 companies, at an average of 4.0x net-debt-to-EBITDA vs. 3.8x.

Putting it all together, although small-cap companies appear significantly cheaper than large-cap companies, this comparison isn’t really apples to apples. Small-cap indices, while indeed cheaper, also reflect larger concentrations in highly indebted and slow-growing sectors (financials and real estate) while not boasting the large concentration that large-cap indices have in the most profitable and fastest-growing sectors (technology and communications). Thus, we do not believe the lower valuation warrants an overweight stance in small caps. However, if investors do want to increase exposure to small caps – based on the valuation discount – we suggest prioritizing quality, e.g., choose the S&P SmallCap 600 Index over the Russell 2000 Index.


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