We are closing out 2024 with a bit more volatility than normal, but the overall trend remains up. To everyone who stops me on the street and asks me, “Why is the stock market up so much?,” I give a fairly simple answer: It’s because the overall profits and margins remain at near record levels. If people persist and ask, “Why is Nvidia up more than 180% this year?,” again, it’s a simple answer: That’s because Nvidia (and Broadcom ) is where the big profit growth is. The direction of profits is the most important determinant of whether stocks go up or down A stock is an investment vehicle to participate in a future stream of cash flow, whether it’s in the form of retained earnings, dividends or buybacks. The most important factor is the direction of earnings: Are they growing or shrinking? By how much? If there is confidence earnings will be growing in the foreseeable future (realistically, that is one to two years out), investors may be willing to pay more for that. That is why “growth” stocks have a higher price-to-earnings ratio than “value” names that do not have stronger growth prospects. Investors follow the direction of earnings growth The S & P 500 is expected to see an overall earnings increase of roughly 10% this year, marking a fourth year of earnings growth. Next year is also expected to see earnings growth. S & P 500 Earnings Growth: 2021: up 52% 2022: up 4.8% 2023: up 4.1% 2024: up 10.2% (est.) 2025: up 14.3% (est.) Source: LSEG Even more important, corporate America is still retaining a very large share of the profits compared to the revenues. The estimated net profit margin (the percentage of revenue that remains as profit after all expenses, taxes and costs have been deducted) for the S & P 500 for 2024 is 12.0%, which is near a record and above the 10-year average of 10.8%, according to FactSet. Tech stocks have been winning because that’s where the profit growth has been In the last three years — but particularly in the last two years — stocks in the technology sector have reported much higher earnings than the rest of the S & P 500. This is largely because of the artificial intelligence story, which has become an investing paradigm the way the internet was in the late 1990s. S & P 500 Technology Earnings Growth: 2021: up 37.3% 2022: flat 2023: up 9.1% 2024: up 20.1% (est.) 2025: up 21.1% (est.) Source: LSEG Unfortunately, because “tech” companies are spread across multiple sectors, and because the largest companies have become so huge, using sectors is not as useful as it used to be when looking at earnings growth. Consider the fact that tech giants Tesla and Amazon are in the consumer discretionary sector, while Meta Platforms , Netflix and Alphabet are in communication services. Further, there are eight companies with trillion-dollar valuations, collectively accounting for nearly $20 trillion in value. This is why the Magnificent Seven can be a better proxy for megacap tech than the S & P technology sector. The pace of earnings growth is megacap tech is slowing, but it’s not clear if investors will buy the rest of the market For 2025, earnings growth for these megacap tech names is expected to remain strong, but it’s anticipated to slow from the torrid pace of 2023 and 2024. “Torrid” is an understatement. Using the Magnificent Seven as a proxy for megacap tech, you can see the dominance of these names based on the earnings outlook: Mag 7 earnings vs. rest of market (2024) Magnificent Seven: up 33% Rest of S & P (493 stocks): up 4% Source: FactSet The rate of earnings growth for the Magnificent Seven is expected remain strong, but it’s anticipated to slow in 2025. Earnings gains for Mag 7 slowing Q4 2024: up 24% Q4 2025 est.: up 18% Source: HSBC Private Banking and Wealth At the same time, estimates for the other 493 stocks are expected to rise, particularly in the back half of the year. S & P 500: bottom 493 estimates Q4 2024: up 4% Q4 2025 est.: up 14% Source: HSBC Private Banking and Wealth This is again causing excitement among the “rotation” crowd, who hope that the other 493 stocks will finally see enough improvement in earnings to entice investors away from the high valuations of megacap tech and into the rest of the market. What would it take to get investors to rotate out of big cap tech? I am skeptical about this rotation hope for two reasons. First, while it is true that with the exception of Apple and Broadcom, all of the megacap tech stocks are expected to see slower profit growth next year, the earnings gains for these names would still be the envy of most other companies. Megacap tech earnings growth: 2024 vs. 2025 (calendar year) 2024 2025 Nvidia 127.6% 50.0% (fiscal year ended Jan.) Amazon 77.1% 20.5% Meta Platforms 51.9% 12.1% Alphabet 38.0% 11.9% Broadcom 22.6% 25.3% Microsoft 11.5% 10.9% Apple 7.9% 10.8% Source: LSEG/CNBC Broadcom earnings are expected to be up 25.3% next year. Nvidia’s earnings are anticipated to rise 50%, while Amazon’s are forecast to climb 20%. You might say that Alphabet, with earnings expected to rise 11.9%, is below the S & P 500’s expected earnings gain of 15%, as is Microsoft and Apple. But that is only because the huge gains from Broadcom, Nvidia and Amazon are pulling the numbers up. Second, the rest of the market is not exactly setting earnings expectations on fire. Look at that estimate above for the other 493 stocks a year from now: up 14%, versus this quarter’s gains of 4%. When investors get used to talking about earnings gains of 127% from Nvidia, a 10% increase doesn’t exactly set the world on fire, does it? You can make all sorts of arguments that valuations (P/E ratios) have risen for these companies too aggressively, but I still think investors would be perfectly happy with far more modest gains, even if P/E ratios came down. For example, what if Nvidia had a terrible year in 2025? What if the stock was only up 5% in a year when the S & P 500 was down 5%? Would there be a mass sell-off in Nvidia, even if there was still 50% earnings growth? The P/E would obviously come down, but would investors abandon it? I am doubtful, unless there is a complete collapse of the AI story. 2025: Lots of wild cards The new year is a bit more unsettled than a lot of people want to believe. True, the incoming Trump administration is very business friendly and it is getting a very strong handoff: a robust economy and still-rising corporate profits. But we really don’t know what the Federal Reserve is going to end up doing. Markets are pricing in a slower easing by the Fed because inflation is still persistent. For example, Tom Lee, head of research at Fundstrat Global Advisors, is still bullish on 2025, but he has noted there is a possibility of at least two “policy errors” that could occur in 2025 that might affect earnings and the economy. First, he notes the Trump administration could enact tariffs that are damaging to the economy. Second, the Fed could become too focused on again fighting inflation and allow the labor market to weaken. Bottom line: There are still a lot of potential landmines out there.
