How megacap earnings will put Wall Street's rebound to the test

Traders on the floor of the New York Stock Exchange. Investors have been drawn to large companies broadly because of their financial strength and competitive advantages that, in theory, will drive profits even during uncertain economic times. AFPShow less

Earnings reports from the four biggest US companies by market capitalisation in the coming week may test a nascent rally where stocks are clawing their way back from another low.

Apple, Microsoft, Google parent Alphabet and Amazon account for a combined 20 per cent of the weight of the S&P 500 and more than a third of the Nasdaq Composite.

Investors view the growth giants as bellwethers for how corporate America is faring during a year in which inflation has soared, pushing the Federal Reserve to quickly enact a series of large rate rises that bruised markets and raised fears a recession may be coming.

“If these megacaps can’t do well, then the question is: who can do well?” said Yung-Yu Ma, chief investment strategist at BMO Wealth Management.

The S&P 500 is up nearly 5 per cent from its October 12 closing low for the year after posting its biggest weekly gain since late June. Even with stocks' latest rebound, the index has dropped 21 per cent so far in 2022, on track for its biggest decline since 2008.

Resilient corporate profits have been one bright spot this year, although doubts are growing over how sustainable they will be.

With the bulk of S&P 500 companies still to report, third-quarter profits are estimated to have climbed 3.1 per cent versus the year-ago period, which would be the weakest performance in two years, according to Refinitiv, while earnings growth expectations for 2023 have fallen to 7.2 per cent from 7.8 per cent on October 1.

Next week's reports from the four megacaps may show whether companies with dominant positions can post solid performance despite worries of an economic downturn.

Because of their heavy weightings, “if those stocks don’t get it done, that puts pressure on the indices to continue to go down”, said Chuck Carlson, chief executive of Horizon Investment Services.

Microsoft and Alphabet are scheduled to report on Tuesday, with Amazon and Apple set for Thursday.

Apple shares are the only ones of the megacaps that have outperformed the broader market this year. Shares of the iPhone maker, which account for a 7 per cent weight in S&P 500, are down about 17 per cent in 2022; Microsoft and Amazon are each off roughly 28 per cent, Alphabet is down 30 per cent.

Apple and Amazon, two of the world's most valuable companies, are due to report their quarterly financial results on Thursday. AFP

Despite those steep losses, investors have maintained exposure to the megacap stocks. Actively managed US mutual and exchange-traded funds held 11.41 per cent of their portfolios in those four stocks combined as of the most recently available data, versus 11.44 per cent at the end of 2021, according to Morningstar Direct.

Investors have been drawn to the large companies broadly because of their financial strength and competitive advantages that, in theory, will drive profits even during uncertain economic times.

Still, only Apple has topped analyst estimates for earnings and revenue in both of their most recent quarterly reports, according to Refinitiv data.

“The bar is higher for Apple because it has outperformed and because you haven’t seen the earnings blink yet,” said Walter Todd, chief investment officer at Greenwood Capital.

Questions loom over the other companies' key market areas, including personal computers for Microsoft, advertising spending for Alphabet and consumer strength for Amazon.

All three rely on cloud computing businesses, which will be in focus next week, according to Charlie Ryan, partner and portfolio manager at Evercore Wealth Management.

If these megacaps can’t do well, then the question is: who can do well?

Yung-Yu Ma,
chief investment strategist at BMO Wealth Management

“Cloud would be the pillar that one would put their hopes on when they report,” Mr Ryan said. “It has been continued strength for quite some time now and any deviation from that would be a concern.”

Meanwhile, soaring US bond yields are pressuring valuations and complicating the picture for tech and other growth stocks, whose expected future earnings are discounted steeply by higher yields. Yields continued to rise this week, with the yield on the benchmark 10-year Treasury note hitting a 14-year high.

All four stocks command higher valuations than the S&P 500, which trades at nearly 16 times forward earnings estimates. The price-to-earnings ratio for Apple and Microsoft are both about 22 times, Alphabet trades at 17.5 times, while Amazon sits at 60 times, according to Refinitiv Datastream.

“Those stocks have typically sold at earnings multiples that are on the higher side,” said Mr Carlson. “How they are going to continue to perform from here gives some insight into what investors are ultimately willing to pay for growth stocks.”