Earnings round up: a bad week for tech doesn’t derail recovery narrative

There were some shocking headlines for tech stocks last week, with earnings data for Microsoft, Amazon, Google and Meta all weaker than expected. Microsoft announced that growth for its cloud services was slowing at a faster rate than expected, Google and Meta were slammed for intensive capital spending and not having their costs under control, while Amazon gave a very bleak outlook for Q4 Holiday spending. Apple was the one bright spot, as it announced that Q3 demand for the iPhone was growing, however, it also saw a slowdown in spending on services, which is where the tech giants make good profits that boost their margins. Overall, the tech sector saw some recovery on Friday, however, this wasn’t enough to reverse some of the biggest losses, including a 25% decline for Meta on Thursday as investors lose confidence in Mark Zuckerberg’s vision for the Metaverse. $250bn was wiped off big tech’s valuation this week, the question now is, will this continue and what could come next?

Big tech’s problems paves the way for other stock market stars

To answer this question, we need some context. US stocks closed higher on Friday and ended up higher for the second straight week in a row, even though big tech is going through an existential crisis. The S&P 500’s equal weight index, which neutralises the performance of the biggest companies in the S&P 500 and normalises all components of the index, increased by 3.5%. The S&P 500 equal weight index had its best weekly back-to-back performance since 2009, while the equal weight S&P 500 index beat the Nasdaq by the most since January. This suggests that tech is acting as a drag on the overall index, with other sectors outpacing it. Investors are moving away from sectors where risk still needs to be priced in and is instead focussing on areas where risk is already priced in, and thus look cheap. For example, financials, consumer staples and utilities are all in recovery mode right now, while tech may still struggle. Aside from its internal and strategic woes,  another problem for the tech sector is that it doesn’t look cheap yet. While Meta is trading at a P/E ratio of 9, Amazon’s P/E ratio is above 50, Alphabet’s is nearly 20, while Apple and Microsoft have P/E ratios around 25. However, the rotation out of the tech sector, US hedge funds have dramatically reduced their exposure to tech from an average of 19% of their portfolios at the start of the year to 11% today, could close the valuation gap with the rest of the S&P 500. The fact that the misery for some of the big tech giants did not spill into the broader market is telling. There is a demand for stocks right now, and a fear about missing out on the next big rally. But while there is demand to own shares, this is still a tricky time to trade financial markets, and to trade stock market indices. There are no easy narratives right now, and earnings season is highlighting how investors need to take a leap of faith when buying stocks in the current environment.

Earnings deep dive

Looking at earnings season for the S&P 500, there has continued to be a decline in net profit margins. This has been driven by higher costs that have hit profit margins. Inflation is above 8% in the US, and producer price inflation rose by 8.5% in September. 412 S&P 500 companies have listed inflation as a concern on their earnings calls for Q3, which is the second highest number for a decade, according to FactSet. Some companies can raise costs in response to inflation, which is why revenue growth is still expected to rise by 8% for Q3. Net profit margins are expected to expand by 12%, however, this would be the fifth straight quarter where net profit margins have declined on a quarter-by-quarter basis. It is worth noting that this is partly to be expected, since net profit margins surged in 2021. Three sectors have seen net profit margin expansion in Q3, led by the energy sector, while eight sectors are reporting a decrease in their net profit margins in Q3 compared to Q3 2021, which is led by financials, which has seen net profit margin in Q3 at 14.9% vs. 16.5% a year ago. These are not dreadful figures, and there is a sense that earnings season is not as bad as some had expected, although the bar was extremely low. What is interesting is that analysts are calling for net profit margins to expand in Q4 and into the first half of 2023, even though inflation is expected to remain elevated for some time. This is one of the key drivers of higher stocks in recent weeks in our view: while things look dark now, there are blue skies ahead.

Reasons for a continued stock market recovery

Thus, with the market looking beyond tech into other, less well-loved sectors of the economy, this is giving tech the chance to close the valuation gap that it has with the rest of the overall S&P 500. This should be good news for tech in the long term – the cheaper it gets the more it is likely to entice buyers. Added to this, sometimes a crisis can lead a company to ditch costly projects that aren’t working and focus on their fundamental strategies, which could improve their stock price in the long term. Thus, Zuckerberg may have to kiss goodbye to his dream of the Metaverse. Another point worth noting is that bear markets historically last 9 months, October is the tenth month of the 2022 bear market, thus a recovery would fit well with history. All of this points to the potential for a more protracted recovery in the market, however, the key driver for global stocks in the coming weeks and months will be what happens at this week’s Fed meeting and if a “dovish pivot” is on its way.