Earnings season will test hopes for broader growth in US stocks

Hopes that the rally in U.S. stocks will extend beyond large-cap stocks like Nvidia will be tested in the coming weeks as investors learn whether earnings growth at other companies is starting to catch up with that of the tech industry leaders.

The S&P 500 is up 16% in 2024, driven by a handful of big-name stocks poised to benefit from emerging artificial intelligence technology. Just 24% of stocks in the S&P 500 outperformed the index in the first half of the year, the third-narrowest six-month period since 1986, according to strategists at BofA Global Research.

Meanwhile, the equal-weighted S&P 500 — a gauge of the average stock — was up only about 4% this year. As of Tuesday, about 40% of the S&P 500’s components have fallen this year.

Second-quarter earnings begin next week, with major banks including JPMorgan and Citigroup reporting on July 12. Investors will be watching to see if other companies’ earnings catch up with the Magnificent Seven: Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta Platforms and Tesla, many of which have rebounded after struggling in 2022.

Investors generally see a narrow rally as more volatile, as weakness in just a few big stocks could send indexes lower, but some are hopeful gains will spread into the second half of the year.

More companies are expected to report improved earnings as many investors expect the economy to experience a soft landing, which could boost stocks trading at more modest valuations than market leaders. “If we’re looking for a catalyst to get more into the rally this year, the second-quarter earnings season could be the start of that,” said Art Hogan, chief market strategist at B Riley Wealth.

The S&P 500 is trading at about 21 times estimated future earnings, Hogan said, but if you exclude the 10 largest companies by market cap, the average for the rest of the index drops to 16.5 times.

In another sign of a modest recovery, the information technology and communications services sectors, which include most of the Magnificent Seven companies, are the only two of the 11 S&P 500 sectors to outperform the broader index this year.

According to Tajinder Dhillon, senior research analyst at LSEG, the earnings of the 7 Great Companies rose 51.8% year-over-year in the first quarter, while the rest of the S&P 500 saw its earnings rise 1.3%.

That gap is expected to narrow, with Magnificent 7’s earnings forecast to rise 29.7% year-on-year in the second quarter and the rest of the index’s earnings forecasted to rise 7.2%, according to LSEG.

“We believe greater balance in yields could lead to broader market participation in coming quarters,” Chris Haverland, global equity strategist at Wells Fargo Investment Institute (WFII), said in a note Tuesday.

WFII suggests investors limit gains in the technology and communications services sectors to benefit from weakness in the energy, healthcare, industrials and materials sectors.

Later this year, Magnificent 7’s profit advantage is expected to narrow even further. The group’s year-on-year profit growth is expected to be 17.4% in the third quarter and 18.3% in the fourth. By comparison, the rest of the index saw profit growth of 6.8% in the third quarter and 13.9% in the fourth.

“We expect nearly all S&P sectors to participate in earnings growth in 2024,” said Katie Nixon, chief investment officer at Northern Trust Wealth Management.

Not everyone is convinced that other groups are ready to catch up, as AI remains a dominant theme. Robert Pavlik, senior portfolio manager at Dakota Wealth Management, said he has doubts that earnings growth will meet expectations, given weak consumer spending, stiff inflation and other troubling economic indicators. Still, investors could get a clearer picture of the health of the economy and when the Federal Reserve will start cutting interest rates in the coming days, which could also trigger broader market gains. Federal Reserve Chairman Jerome Powell is scheduled to testify before Congress on Tuesday, while Thursday’s release of the monthly consumer price index provides a key look at inflation.

Regardless, Federal Reserve policymakers received more evidence Friday of a cooling U.S. labor market, which could bolster their confidence in a victory over inflation and pave the way for a more active debate on interest-rate cuts at their next meeting in late July.

The Labor Department’s report showing rising unemployment and falling job creation is just the latest in a series of recent data that provides more evidence of a slowdown than what U.S. central bankers had at their June meeting.

At the time, many of them believed inflation was so weak and the economy still so strong that they would likely cut rates only once this year, if at all.

Since then, the data has gone in the opposite direction. Several inflation reports showed that prices did not rise at all from April to May; other reports signaled a decline in activity in services and manufacturing and an increase in vacancies and layoffs. Friday’s jobs report showed no major cracks in the labor market – in fact, the 206,000 job gain in June exceeded economists’ expectations.

However, the unemployment rate rose to 4.1% and big revisions to the previous month’s estimate for job creation pushed average monthly payroll growth over the past three months down to 177,000.