*If the Earnings Pan Out
Last Thursday’s precipitous decline saw the S&P 500 close at its cheapest valuation in three years, yet we’d still hesitate to affirm that valuation was a bargain. The index traded at 17.7 times the earnings analysts expect over the next twelve months, according to FactSet; that’s the lowest forward price/earnings multiple (what investors pay for each dollar of profit) since November 2023, and well under the ten-year average of 19.1. But the catch is in how it got there: stock prices were up about 7% for the year at that point, while the earnings forecast underneath them had risen almost 34%. In a nutshell, the market is “cheap” only if that forecast comes true.
Robust Profit Growth
Profits have indeed had a remarkable year. With most companies reported, third-quarter earnings are running about 31% above last year’s, the third straight quarter of growth above 25%, and analysts expect another 16% in 2027.
Analysts tend to be too hopeful, of course, especially after a few years of bull market and in the throes of an industrial revolution that’s rewarding its economic epicenters with spectacular growth. Over the last 25 years, analysts’ forecasts at the start of a year typically ran about 6% above what companies went on to earn. That average is pulled up by a few very large overestimations. The two largest were 2001, when forecasts proved 36% too high, and 2008, when they proved 43% too high. Both came at the end of long profit booms. The second followed a four-year period, 2003 through 2006, in which analysts kept raising their numbers to keep up with results — as they have this year.
At its peak in October 2007 the S&P 500 traded at about 15 times expected earnings, cheaper than today. The price looked sensible, and the index still fell by more than half, because the earnings it was measured against never arrived. In short, a “low” multiple on a record forecast is only as cheap as the forecast is correct.
The Road to 7,000
Larry Jeddeloh of TIS Group, a strategist we read closely, wrote on Monday that the S&P 500 “should trade back toward 7,000 for starters.” That is about 7% below Tuesday’s close of 7,521 and about 10% below October’s record, which would make it an ordinary “correction” (the market’s term for a 10% decline from a peak).
Larry gets there by way of war, liquidity, and a loss of confidence. To us, there is a simpler and less alarming path that gets us there that does not require geopolitically derived chaos: profit growth this strong is hard to maintain. Trim the forecast by FactSet’s average 6% miss and today’s multiple rises from about 18 to about 19, which is the ten-year average, and the discount is gone. At 7,000 the index would trade at just under 18 times the trimmed figure. If forecasts need to slip only in line with their long-run tendency, 7,000 is roughly where “cheap” starts to be correct. And of course, there is another item in the mix… inflation and rising rates.
Inflation
Inflation has run hotter than the market expected. Investors began the year pricing in two interest-rate cuts from the Federal Reserve; in September they got the first increase since 2023. On Tuesday the government reported that consumer prices rose 0.4% in October from September, with the core measure (which leaves out food and energy) up 0.3% for a third straight month. Futures markets now treat a second increase in December as a near certainty, and one Fed governor has said a half-point move should be considered. The ten-year Treasury yield is back at about 5%.
A Treasury paying 5% competes favorably, in many minds, with a stock market whose expected earnings come to about 5.5% of its price. A Fed that is raising rates might also be slow to come to the market’s aid. BofA’s economists argued after October’s strong jobs report that investors should count on less of the “policy put” — Wall Street’s shorthand for the Fed easing if stocks fall far enough.
Company managements are saying much the same. By Jefferies’ tally of third-quarter calls, they cited inflation, higher rates and supply constraints as reasons for near-term caution, even as three in four stayed upbeat about 2027.
This letter is general commentary — the wide-angle view. It is not a portfolio. What we do for the families we work with is the opposite of “wide-angle”: we make portfolios built around one household’s circumstances, taxes, timelines, and appetite for exactly the kind of volatility described above. We keep that roster of clients deliberately small, because that sort of attention doesn’t scale. If you’d like to talk about what it would look like for you, contact us; we will make the time.
Jettison Huang
This morning Jensen Huang resigned as chief executive, president, and director of Nvidia (NVDA), the company he co-founded 33 years ago. As recently as Sunday the board had expressed confidence in him, despite reports of a relationship with a suspected Chinese intelligence operative that drew inquiries from the FBI and Congress. What ended it came on Wednesday, when The New York Times reported a second relationship, with a senior Nvidia executive who reported directly to him, which made it the company’s business as well as his own. The board met Wednesday to weigh removing him, and by this morning he was gone. Chief financial officer Colette Kress is interim CEO while the board searches inside and outside the company, and the shares fell about 10% before the open.
We’ll leave the soap opera to others. An ultra-enthusiastic, charismatic founder’s reign usually ends one way or another, and this is how Jensen’s ended. What matters for investors is what leaves with him. Huang was the AI boom’s chief dealmaker and chief cheerleader. He struck the partnerships, often investing in the very customers that buy Nvidia’s chips, and he sold the vision from the stage. We expect deal and decision-making will be slower, with more deliberation. We expect the deal structures to change, with fewer arrangements in which Nvidia finances its own customers, and less ‘aggressive’ commitments all round. Some companies might see immediate gains. Broadcom (AVGO), which designs custom AI chips for the largest cloud companies, may benefit as those customers hedge their reliance on a single supplier. There are others who stand to benefit from internal turmoil at Nvidia, but we do expect the overall AI spending cycle to run more slowly than it has… which is one more grain of salt on next year’s earnings forecasts.
AI’s Productivity Gains Are Measurable, So It’s Not Going Away
However, a counterpoint: double-digit growth could repeat if productivity keeps improving. This week brought stronger evidence that it will.
Morgan Stanley’s strategists ran roughly 18,000 earnings-call and conference transcripts through an AI language model, looking for companies that put a number on what AI has done for them. Over the past twelve months, 44% of S&P 500 companies cited at least one measurable benefit, up from 32% a year earlier. The share citing a direct financial effect, meaning costs saved or revenue gained, rose from 16% to 26%. Financial companies are furthest along, at two in three. The companies that report such numbers most consistently have also seen their earnings forecasts rise faster than the rest of the index.
In 1999, the internet’s payoff was mostly a promise. AI’s is now appearing in reported results, well beyond the largest technology companies: so far this quarter, the other 493 companies in the index are growing earnings faster than those seven, the so-called “Magnificent Seven,” which FactSet says would be a first since 2022. Costs are being counted as well: the share of companies discussing what AI costs them nearly tripled from a year earlier, to 22%, and Morgan Stanley is careful to call the measurement of returns “early.”
Still, more than four in ten large companies are now putting numbers on AI’s payoff, which is an argument in favor of continued earnings strength.
Implications
The large earnings misses of 2001 and 2008 took recessions to produce, and an economy that added 165,000 jobs in October, with unemployment at 4.1%, is not recessionary, or headed visibly in such a direction. If a correction comes, we expect the ordinary kind, and that kind is congenial to long-term investors. In the meantime, with the Fed’s policy rate just under 4% and likely to rise, cash and short-term Treasuries pay while the forecasts are tested and afford dry powder to take advantage of a deeper correction if one occurs.
Thanks for listening; we welcome your calls and questions.
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