What the Nifty Fifty can tell us

This article was originally published in The Telegraph.

IN the short term, share prices and markets bounce around because of changing sentiment. How we feel about the economy, interest rates - even our own personal financial position - colours our view of the investment outlook. Longer term, however, the more important driver is less subjective. It is the company earnings of which we are all buying a small share. Every three months, during results season, we get a snapshot of what really matters. And that moment is upon us again. 

Friday’s second quarter earnings announcements from JP Morgan, Wells Fargo and Citigroup are the traditional curtain raiser, setting the scene for a flood of results over an intense period of three or four weeks. Results season always matters, but the second quarter earnings that start to be unveiled this week feel unusually important. The hope is that they will offer some clues about the strange disconnect between what the stock market ought to be doing and what it actually has been. 

Since last autumn, investors have become increasingly sanguine about the outlook. Nine months ago, they were prepared to pay 15 times expected earnings for a share of the US market action. Today they are willing to pay nearly 20 times. That is a puzzle. On the basis of the change in interest rate expectations and bond yields over that period, it would have made more sense if that valuation multiple had fallen, to maybe 12 or 13 times earnings.  

Investors have decided, rightly or wrongly, that the economy is less sensitive to rising borrowing costs than it used to be. What looked like highly restrictive monetary policy six months ago, now appears less daunting. What looked like a near certain recession is now less likely. A soft landing is back on the table.  

This glass half full assessment is reflected in earnings forecasts. The consensus view is that the latest quarter was as bad as it gets. The predicted fall in profits of up to 9%, year on year, is expected to reverse in the second half of 2023 and through next year, with earnings rising by 10% or more in 2024. That will seem even more plausible if there is a repeat of the first quarter results season, when analysts started out looking for a high-single-digits fall in earnings and were pleasantly surprised by the 3% decline that was delivered instead. 

It’s worth noting that the average fall in earnings is just that, an average. There is a wide dispersion in forecasts between sectors, with energy, materials and healthcare companies expected to see falls of 20% or more while consumer-facing businesses enjoy higher profits on the back of a surprisingly robust jobs market and rising incomes. Once the adjustment in the cost of oil and other commodities passes through the comparatives, the overall picture could look more positive. 

The most important sector to watch, of course, is technology. In particular, the success or otherwise of this earnings season could be determined by the handful of companies that have collectively been responsible for the remarkable rise in the US market this year, and especially of the tech-heavy Nasdaq index, which is up more than 30% year to date. 

Without the breath-taking surge in the value of Alphabet, Apple, Amazon, Microsoft, Nvidia, Meta and Tesla - dubbed, inevitably, the Magnificent Seven - the first half of 2023 would have looked less impressive. Since January, the worst of these stocks has risen by 35% (Alphabet), two have more than doubled (Tesla and Meta) while the stand-out performer, Nvidia, has almost trebled in value. 

In a couple of cases, this appreciation can be justified by tangible growth in profitability. Nvidia, in particular, blew away analysts’ forecasts in the first quarter, and Meta is growing fast too. But, in the main, the price growth simply reflects higher valuations. Apple and Microsoft are valued at more than 30 times forecast profits. Nvidia, Amazon and Tesla will cost you more than 50 times earnings. 

So, there is plenty of scope for disappointment. With the exception of Nvidia and Meta, earnings expectations are not that exciting. With the kind of nosebleed valuation multiples these companies enjoy, anything other than a big positive surprise might be punished. 

Parallels with the dot.com period in the late 1990s are becoming more frequent, but the more interesting analogy, I think, is with the early 1970s when a group of reliable, high-growth companies - collectively known as the Nifty Fifty - captured investors’ imaginations in exactly the same way as the Magnificent Seven have today. 

The parallel is more exact than the 1990s tech bubble because the economic backdrop in the 1970s was similar - faced with extreme uncertainty (war, inflation), investors gravitated towards what they could trust. They bought these so-called ‘one decision’ buy and hold stocks, with little concern for the price that was being asked for that perceived security. 

During the first half of the 1970s, the average valuation of the top 50 companies in the S&P 500 index was as much as twice that of the other 450 stocks. The premium persisted through both up and down markets. No price was too high for the safe haven that shares like Kodak, Xerox and IBM seemed to provide. 

It was not to last, however. During the grinding inflation-adjusted bear market that endured from the 1974 market crash until the bottom was reached in 1982, the valuation premium enjoyed by the Nifty Fifty progressively narrowed. Eventually there was no difference at all between how investors viewed the former stock market favourites and the rest of the pack. 

The jury is out on whether the Magnificent Seven will continue to attract their premium rating. But it is telling that hedge funds have cut their bets on continued US stock market leadership to the lowest level in at least a decade. The next few weeks’ barrage of earnings announcements could start to show if they are right to be sceptical.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.