Big Tech Stocks Experience Slowing Earnings Growth

Slowing profit growth is impacting the perceived strength of the major tech companies as they prepare to report their earnings this week. Investors are curious whether these giants can reverse this trend, which will play a significant role in the continuation of the stock market rally.

The five largest companies in the S&P 500 Index by market capitalization—Apple Inc., Nvidia Corp., Microsoft Corp., Alphabet Inc., and Amazon.com Inc.—are forecasted to see an average earnings growth of 19% in their third-quarter reports, as per the data gathered by Bloomberg Intelligence. While this growth rate is much higher than the expected 4.3% rise for the S&P 500, it represents the slowest collective growth for these companies in six quarters.

Furthermore, the earnings growth gap between Big Tech and the broader market is expected to continue narrowing into 2025, making last year's roughly 35% quarterly earnings growth seem like a thing of the past. This raises questions for investors about what this slowdown in growth means for these stocks, which have significantly increased in value during the recent market rally.

“Sentiment is more uncertain than in previous quarters, and the factors influencing the market feel increasingly negative,” remarked Andrew Choi, a portfolio manager at Parnassus Investments in San Francisco. “This doesn't imply the rally is finished, but there are emerging opportunities elsewhere, particularly amidst discussions around Big Tech valuations, slowing earnings momentum, and controversies impacting sentiment.”

Market Rotation

For the majority of the past two years, the tech giants have been the driving force behind the rise of the S&P 500, supported by relentlessly growing profits and investor willingness to pay higher multiples for these earnings. However, this trend appears to be shifting.

Since reaching a peak on July 10 after a robust 22% rally early in the year, the Bloomberg Magnificent 7 Index—which includes the five S&P giants along with Meta Platforms Inc. and Tesla Inc.—has decreased by 2%. This decline contrasts with gains of more than 10% from utility, real estate, financial, and industrial sectors, while the overall index has risen by 3.1% during the same period.

This situation has put the Big Tech companies in an unfamiliar position: that of underdogs in the stock market. They are now facing increased scrutiny regarding their high valuations, as well as questions about the timing of returns on their substantial investments in artificial intelligence.

“The shift in tech's market leadership could persist until the year's end, but this doesn't deter our long-term ownership of these stocks,” stated Ross Mayfield, an investment strategist at Baird. “While the risk of decelerating earnings growth and elevated valuations is present, these companies still bring considerable growth opportunities and potential for earnings upside in the years to come.”

Although Tesla has already reported better-than-expected third-quarter profits and an optimistic outlook, the main part of the Big Tech earnings season commences this week. Alphabet, the parent company of Google, reports its earnings on Tuesday, followed by Microsoft and Meta Platforms on Wednesday, and Apple and Amazon on Thursday.

Focus on AI Investments

Each company reporting this week has its unique challenges. Microsoft faces scrutiny regarding its AI prospects, while Apple has seen early signs of lukewarm demand for its latest iPhones, although optimism about the future has driven the stock to a record last week. Amazon investors are concerned about its high capital spending impacting profitability, and Alphabet remains shrouded in regulatory uncertainty as the US Justice Department investigates its market practices.

Artificial intelligence will be a key focus for investors monitoring these earnings reports, especially regarding the companies’ spending on expensive infrastructure. For the third quarter, Microsoft, Alphabet, Amazon, and Meta are projected to have invested approximately $56 billion in capital expenditures, marking a 52% increase from the same period a year prior.

Investors generally believe that these companies' investments in AI represent the future of technology. However, tangible profitability from these expenditures remains elusive, especially for companies like Microsoft, which incorporates AI features into its software products. Disappointment regarding the gap between AI investments and expected returns hindered an otherwise strong second-quarter earnings season and has raised concerns about future profit margins.

“Top-line growth is starting to be countered by soaring AI-related capital expenses,” noted Bloomberg Intelligence strategists Gina Martin Adams and Michael Casper. “This suggests that peak margins may already be behind us, at least for the short term.”

The recent underperformance of Big Tech correlates with a shift in sentiment from Wall Street's institutional investors. Hedge funds have been divesting from the Magnificent Seven stocks over recent months. Despite some moderate buying in October, net long positions as a percentage of total US exposure are still around the lowest levels since mid-2023, according to data from Goldman Sachs.

Valuation Concerns

Even with the decline in mega-cap stock prices, many of these companies maintain valuations exceeding historical averages. Apple is currently trading at 32 times estimated profits for the next year, higher than its average of 20 times over the past decade. Microsoft is priced at 33 times, as opposed to an average of 25.

“For those considering tech investments, the critical question is whether earnings growth will be sufficient to match these multiples, or if recent strength is merely driven by fear of missing out,” said Clark Bellin, chief investment officer at Bellwether Wealth. “While momentum is a factor, at some point the rapid rise in stock prices may halt, and expectations need to be tempered this earnings season.”

Despite the slump in prices, Wall Street experts remain largely optimistic about Big Tech. Approximately 90% of analysts covering Microsoft, Alphabet, and Nvidia have issued buy ratings, according to Bloomberg data. The figures reveal 83% for Alphabet and 65% for Apple, during a time when the average S&P 500 company sees a buy rating from around 53% of analysts.

The optimism primarily stems from the reality that, despite concerns, these companies continue to deliver above-average profit growth, advantageous exposure to AI, strong capital returns, and relatively lower risks compared to other stock market sectors, according to Choi from Parnassus.

“It's challenging to find dominant businesses that generate this level of earnings growth,” he concluded. “There remains much to appreciate in this sector.”

Tech, Stocks, Earnings, AI, Growth