Stocks Priced for ‘Sunshine and Rainbows’ Now Face Earnings Test

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The setup for sectors that are still seeing accelerating growth and sharp share-price gains, like semiconductors, is “precarious” and the companies had “really better deliver” to meet heightened expectations, said Marta Norton, chief investment strategist at Empower.

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“What analysts are putting out there is really astonishing,” she said.

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AI Bills

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Tech stocks are center stage this earnings season as the biggest drivers of market rallies in the US, Taiwan and South Korea. In the US, information technology companies are expected to post 67% profit growth, second-best among S&P 500 sectors after energy at 118%, BI figures show.

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But investors have been hard to impress. Blowout results from Samsung Electronics Co. and Micron Technology Inc. failed to push semiconductor stocks higher amid concerns of bloated valuations. The MSCI World Semiconductors & Equipment index hit a record on June 22, but is down 6.1% since then, making next week’s reports from ASML Holding NV and Taiwan Semiconductor Manufacturing Co. key.

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Meanwhile, results in a few weeks from the big spenders on AI infrastructure — Alphabet Inc., Amazon.com Inc., Meta Platforms Inc., Microsoft Corp. and Oracle Corp. — will offer guidance on whether their investments are paying off. The group was among the biggest winners in the AI trade until recently, when investors turned skeptical on how much cash is heading out the door. 

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The largest US AI companies are expected to shell out more than $700 billion in capital expenditures this year. However, changes in spending are a double-edged sword. A decline could be well received, but pulling back too hard could spook investors by showing a lack of confidence in those investments paying off. 

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“If you start to see too much debt issued, then the market will say this is too much,” said Daniel Murray, deputy chief investment officer at EFG Asset Management. “But equally, if you don’t have any capex, the market wouldn’t like that either.”

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That said, so-called AI hyperscaler stocks look “way oversold,” making their valuations attractive, according to Jay Hatfield, chief executive officer at Infrastructure Capital Management. He’s bullish on Amazon as well as Apple Inc., which is largely sitting out the spending race.

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Margin Compression

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The oil shock that roiled markets earlier this year may continue now that the ceasefire between the US and Iran appears to be over. That was unwelcome news for stock investors, who have to look past inflation at a three-year high, rising prices for memory chips and expectations of Fed rate hikes. Profit margins are expected to shrink across S&P 500 sectors, with notable exceptions in energy and materials.

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Market leadership is shifting, with cyclical sectors like semiconductors expected to benefit from the heavy capex spending by AI hyperscalers, said Savita Subramanian, head of US equity and quantitative strategy at Bank of America Corp. 

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Indeed, cyclicals is one of the few parts of the S&P 500 where Wall Street expects to see minimal erosion in profit margins. In contrast, growth companies are projected to post a decline in second-quarter profit margins to 30.8% from 35.4% in the January-March period. Margin compression is projected to be even more dramatic for the Magnificent Seven tech giants, down to 27.7% this quarter from 36.2% in the prior one, with many of the firms spending hundreds of billions of dollars building out AI infrastructure. 

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“High valuations in the mega-cap tech space are creating vulnerabilities to any signs of weaker margins or slower capex spending growth,” Brian Jacobsen, chief economic strategist at Annex Wealth Management, wrote in a note on July 6.

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Europe, Asia

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Investors seeking diversification from the US technology trade are finding bargains in some European and Asian stocks. In Europe, Deutsche Bank strategists expect Stoxx 600 firms to report a 12% jump in second-quarter earnings, following a 7% rise in the first quarter. Profits for MSCI Asia Pacific constituents are estimated to rise 39%, up from 6.9% in the previous three months, data compiled by Bloomberg show.