The Great Eight of the S&P 500 are in a totally different league from the rest

How can investors compare the Great Eight of the S&P 500 to the other mere mortal firms? The Great Eight companies have risen as titans in their heavenly realm. A digital realm that most other companies can hardly enter let alone effectively compete with such godly giants. Comparing these eight to the rest of the S&P 500 or S&P 100 or the largest S&P firms from past decades is extremely difficult. Moreover, comparing such titans to small caps or most foreign stocks or other asset classes like bonds, real estate or commodities has become farcical if not comical. One should find more earthly comparisons before concluding that other stocks or asset classes are “cheap.” We present such earthly comparisons for the S&P 492  (S&P 500 minus the Great Eight) and argue the Great Eight should be evaluated on a stand-alone basis using intrinsic valuation models or constructs.

EPS yields vs. real interest rates can measure mortals, but gods require DCFs

Despite a 10% correction from its 1-year high and finally a resumption of modest year-over-year (y/y) earnings per share (EPS) growth upon generally good 3Q results so far, especially at Tech & Communications, the S&P trades at about 18.5x current EPS or an earnings yield of nearly 5.5%. Excluding the Great Eight, which trade at about 30x current EPS in aggregate and represent 18% of S&P EPS but 29% of market cap, the S&P 500 or S&P 492 trades at about 16.5x current EPS. Also, excluding Financials & Energy, the S&P 492 trades at about 18x current EPS.

We won’t compare the EPS yield of the Great Eight to real interest rates, but the nearly 6% EPS yield of the S&P 492 is only 350bp above the 2.5% real yield on 10yr Treasury Inflation-Protected Securities (TIPS). Normally this spread or Equity Risk Premium is closer to 400bp or higher when VIX is well over 15 and investment grade bond spreads over 125bp and high yield over 400 basis point (bp) as all are today. And while EPS yields are higher at Financials and Energy than S&P 492, the credit spreads available from the issuers of these sectors are also higher than average credit spreads. Thus, we generally see corporate bonds as an asset class more attractive than S&P 492 right now. Otherwise, it would take over 7% EPS growth in 2024 & 2025 from the S&P 492, which we think unlikely and if US slips into a small recession it would likely be flat or down.

It's hard to know what price-to-earnings (P/E) multiple the Great Eight will be able to sustain, but over time we think it will very likely decline. If the 10yr TIPS yield stays near 2.5%, we think the aggregate PE at the Great Eight is likely to fall to 25x or less over the next two years. Thus, for investors to earn an annual 10% gain while the PE contracts from roughly 30x to 25x the required annual EPS growth must be 20%. Maybe the gods will deliver, maybe they won’t. Building discounted cash flow (DCF) models to explore various growth scenarios and the required Capital expenditure (Capex) and other investments needed to support such growth scenarios along with testing the valuation sensitives to cost of capital assumptions are ways to reveal the most credible prophecies.

3Q EPS Tracker: Good, Tech and strong 3Q GDP boosted; cautious outlooks

245 S&P 500 companies comprising 63% of the index earnings have reported. 72% beat on EPS and 25% missed (the rest in-line), with an aggregate surprise of +7.1%, +6.8% ex Financials. Much stronger than the historic average EPS beat of +3.3% (2011-2019 avg). Bottom-up blended (actual for reported and consensus for the rest) 3Q EPS is $56.74, +3.9% y/y. Blended sales growth is +1.1% y/y. Blended pro-forma net margin is 12.9%, vs. 12.0% in 2Q23 and 12.6% a year ago.

Please see our EPS Tracker slide deck as kept up to date on the DWS Americas CIO View website.

Still watching 10yr Treasury & 10yr TIPS yields: Fed is not bond market’s friend

Federal Open Market Committee (FOMC) decides on November 1st, but recent speeches suggest that the Fed is less hawkish. They see hikes so far as probably or nearly enough to sustain the decline in inflation. But a complacent Fed risks a more bearish bond market, especially given the worsening deficit. If 10yr yields exceed 5%, we think the risk of a worse than very “soft recession” will climb.

Next 5%+ S&P price move signal changed from Down to Balanced Risk

We change our signal to Balanced Risk of the next 5%+ S&P price move being up or down. We expect a rangebound S&P between 3900-4300 into yearend and 4000-4600 next year. Our fair intrinsic value targets for the S&P 500 are 4100 at 2023 end and 4500 2024 end. However, we see downside risk on the assumptions underlying these targets. Reporting season is confirming resilience and growth at the mega cap Tech/Digital firms. Thus, we’re now more confident that S&P EPS will be about $222 in 2023 and between $230 to $240 in 2024 amidst slow GDP. We’re likely to stick with $235 S&P EPS in 2024 or 6% growth. This assumes a resilient US job market, benign credit costs at big banks, no further dollar appreciation nor deterioration in global manufacturing output/demand, yet some contraction in consumer goods spending but no plunge. We expect positive yet very low single-digit EPS growth at most S&P sectors and industries next year, but high teens EPS growth from Tech and Communications to spruce the overall S&P EPS growth rate to 6%.