Slowdown in Big Tech Earnings Raises Concerns

The slowing growth in profits is casting a shadow over the perceived strength of major tech companies, as they gear up to announce their earnings this week. The outcome of these reports will significantly influence the ongoing stock market rally.

According to data from Bloomberg Intelligence, the five largest firms in the S&P 500 Index by market value — Apple Inc., Nvidia Corp., Microsoft Corp., Alphabet Inc., and Amazon.com Inc. — are expected to show an average earnings growth of 19% in their third-quarter results. While this figure exceeds the S&P 500’s projected growth of 4.3%, it marks the slowest growth rate for these tech giants in six quarters.

Additionally, the earnings growth gap between Big Tech and the rest of the market is anticipated to close further by 2025, diminishing the explosive quarterly growth rates of around 35% seen last year. Investors are now left wondering how this trend will affect stock performance, especially considering the substantial rallies observed in recent months.

“Sentiment is shakier compared to previous quarters, and the issues impacting the market feel rather negative,” noted Andrew Choi, a portfolio manager at Parnassus Investments in San Francisco. “While this does not necessarily spell the end of the rally, there are alternative investment opportunities to consider, particularly as debates over Big Tech valuations and slowing earnings continue.”

Market Shifts

Over the last couple of years, the tech giants have been the main driving force behind the S&P 500’s upward trajectory, driven by continuous profit increases and investor readiness to pay higher prices for those earnings. However, this trend appears to be shifting.

Since its peak on July 10, after a 22% rally at the start of the year, the Bloomberg Magnificent 7 Index — including the five large tech firms alongside Meta Platforms Inc. and Tesla Inc. — has declined by 2%. This underperformance places it behind all major S&P sectors, with utilities, real estate, finance, and industrial sectors gaining more than 10%, while the broader index has seen a 3.1% rise.

As a result, these once dominant tech companies find themselves in an unusual position: that of market underperformers. With elevated valuations and increased scrutiny regarding the payoff from their investments in artificial intelligence, these firms face challenges they are not accustomed to.

“The fact that tech is losing its leadership role could extend until the end of the year, but that doesn’t deter us from long-term investments in these companies,” explained Ross Mayfield, an investment strategist at Baird. “Although there are risks involved with slowing earnings growth and possibly inflated valuations, these firms have significant growth potential ahead.”

While Tesla has already posted promising third-quarter profits and issued a favorable outlook, the core earnings season for Big Tech kicks off this week. Alphabet reports on Tuesday, followed by Microsoft and Meta on Wednesday, and Apple and Amazon on Thursday. Nvidia won’t release its financial results until late November.

Focus on AI Investments

Each company reporting this week faces its own set of challenges. Microsoft is exploring its future in AI, while Apple is noticing softer demand for its new iPhone models, although longer-term optimism led the stock to a record high last week. Amazon's investors are anxious about how heavy capital spending might impact profits, and Alphabet is dealing with regulatory scrutiny from the U.S. Justice Department regarding its monopoly practices.

Investors will closely watch how much these firms are investing in AI infrastructure. For the third quarter, Microsoft, Alphabet, Amazon, and Meta are projected to invest a total of $56 billion in capital expenditures, representing a 52% increase compared to last year.

While many investors believe that these AI investments are the future of technology, there isn't much evidence to suggest that immediate profitability will follow, as seen with Microsoft’s integration of AI features into its products. Disappointment over the balance between AI spending and profit outcomes has overshadowed an otherwise positive second-quarter earnings report, raising concerns about future profit margins.

“Top-line gains are starting to be balanced out by rising AI-related capital expenditures,” stated strategists Gina Martin Adams and Michael Casper from Bloomberg Intelligence. “This can indicate that peak profit margins are likely behind us in the near term.”

The recent dip in Big Tech stocks aligns with a decline in positive sentiment from hedge funds on Wall Street. These funds have been selling shares within the Magnificent Seven over the past few months, and despite a modest uptick in October, net long positions as a share of total U.S. investments are still hovering near their lowest levels since mid-2023, according to data from Goldman Sachs.

Valuation Challenges

Despite the downturn in megacap stocks, several of these companies still exhibit valuations that surpass historical averages. For instance, Apple is trading at 32 times its estimated profits for the next 12 months, compared to an average of 20 times over the past ten years. Microsoft stands at 33 times compared to its average of 25.

“When evaluating tech, one must consider if earnings will truly grow enough to justify these valuations or if recent strong performance is merely fueled by a fear of missing out,” stated Clark Bellin, Chief Investment Officer at Bellwether Wealth. “Momentum plays a role, but at some point, investors need to temper their expectations this earnings season.”

Nevertheless, the vast majority of Wall Street experts remain optimistic about Big Tech. Approximately 90% of analysts covering Microsoft, Alphabet, and Nvidia have buy ratings on their stocks, according to Bloomberg data. The buy ratings stand at 83% for Alphabet and around 65% for Apple, while the average rating for S&P 500 companies is about 53%.

The rationale behind this optimism is straightforward. Despite the challenges, these companies continue to deliver above-average profit growth, provide exposure to AI opportunities, and pose less risk compared to other stock market sectors, according to Choi from Parnassus Investments.

“Finding dominant businesses that exhibit this level of growth is no easy task,” he concluded. “There are still many attractive factors to consider.”

Tech, Earnings, Investors