Technology-related revenue continues to contribute

As large-cap U.S. stocks, especially U.S. tech stocks, continue to hit new highs, many investors are wondering if we've reached “bubble” territory. There is debate over whether current valuations are justified, whether impressive earnings growth can be sustained, and calls for rotation into less popular segments of the market. The rise of companies like Nvidia (NVDA), MicrosoftMSFT (MSFT), and Meta (META), in particular, has been truly impressive, but it's also justified by their earnings results, which have consistently blown away analyst expectations. As the market capitalization of these large companies swelled, smaller, less profitable companies were left behind.

As we mentioned in our November 2023 commentary (“The mediocre 493 may start to rival the Magnificent Seven”), market laggards have significant relative value, and the Fed begins to cut interest rates. It seems that it should appear soon. In fact, since this announcement, the chart below shows that even-weighted S&P (RSPRSP) and small-cap stocks (IWMIWM) have outperformed the traditional market cap S&P index (SPYPYSPY ). Continue to lead the group.

Exhibit 1. Since November 30, 2023 – Performance of RSP, SPY, MAGS, and IWM ETFs

The market seems to be looking to expand exposure, but at the same time technology continues to garner the most attention and attract investor money. For those concerned about valuation bubbles in tech companies, earnings growth continues to defy those claims. Earnings per share growth for large tech companies is exploding and shows no signs of slowing down. Currently, S&P predicts that the tech sector's revenues will grow by 29% in 2024 and another 17% in 2025. Based on these metrics, the tech sector would be far from a bubble, trading at less than 20x his 2024 EPS and around 17x his 2025 EPS. region.

The Magnificent Seven stocks make up more than 40% of the Nasdaq 100 index and have experienced explosive profit growth over the past three years, as shown in the chart below. In 2021, forward and trailing EPS were around $350, but in 2024, forward EPS nearly doubled to $675, and trailing EPS grew by just under $600. The tech giant's recent earnings reports have mostly shown an optimistic outlook, so there's reason to believe that future EPS will continue on an upward trajectory.

Exhibit 2. Forward EPS and Trailing EPS – Nasdaq 100

As tech companies' earnings continue to grow at an impressive rate, rotating candidates have not been able to keep up in terms of EPS. It is well known that his 40% of small cap stocks in the Russell 2000 are unprofitable. MSCI EAFE (Europe, Australia, Far East), the developed world international benchmark, has experienced stagnant EPS growth dating back to 2007, before the global financial crisis. This explains why, even though everyone is piling money into large-cap tech stocks, the majority of investors remain reluctant to invest out of tech stocks. Still, laggards have very low valuations, so they remain an attractive value proposition when interest rates start to fall.

Investors shouldn't wait for the Fed (or ECB, Bank of Japan, or other central banks) to announce their first rate cut. Buying on the news usually means buying too late. Additionally, the potential efficiencies of breakthroughs in artificial intelligence (AI) are just beginning to be realized and could extend beyond the technology sector. Currently, the biggest beneficiaries of advances in AI are technology companies, who are at the forefront of advances almost every day. But this progress will circulate throughout the economy, with non-tech companies (customers of big tech companies) reaping side benefits as AI increases efficiency and profitability.

AI could be a catalyst for improving the profitability of a portion of the small-cap 40% underperforming population and could replace human workers in many tasks. Chatbots are already responding to customer inquiries, and some companies are using AI to write software code to create marketing materials, website copy, and other publications. No doubt more use cases will emerge as companies seek innovative ways to increase profitability. As we've seen with large-cap AI, upward momentum can be rapid and sudden, so it makes sense to establish a position in advance.

Tech companies have a proven track record of profitability and are expected to continue doing so in 2024. With interest rates expected to fall, we could see similarly strong earnings growth from undervalued parts of the market.

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