During this earnings season for the S&P 500: the first time in 2023, the growth rate of "7" profits slowed down, while the profit growth of "493" increased?

In the latest research report on July 9th, Bank of America Merrill Lynch stated that as the curtain rises on the second-quarter financial reports, apart from the "Big Tech Seven," 493 other companies in the S&P 500 index are expected to usher in the first quarter of EPS growth, breaking the trend of flat or declining earnings for five consecutive quarters.

The growth of the technology stocks "Big Tech Seven" is expected to slow down for the second consecutive quarter and slow down again in the third quarter. The narrowing of this growth differential will serve as a catalyst for market expansion.

Bank of America Merrill Lynch believes that considering the profit cycle of non-tech stocks, more cost-cutting efforts will bring better profit margin growth for the other 493 companies in 2024-25.

493 Companies Welcome the First Quarter of EPS Growth

Bank of America Merrill Lynch believes that, apart from the "Big Tech Seven," 493 other companies in the S&P 500 index will welcome the first quarter of EPS growth.

In contrast, the EPS of the S&P 500 index has grown year-on-year for three consecutive quarters, while the profits of the other 493 companies have remained flat or declined over the past five quarters. On the other hand, the growth of the technology stocks "Big Tech Seven" is expected to slow down for the second consecutive quarter and slow down again in the third quarter. Bank of America Merrill Lynch expects that this narrowing growth differential will be a catalyst for market expansion.

Bank of America Merrill Lynch believes that one of the reasons why the profits of the technology stocks "Big Tech Seven" recovered earlier than the other 493 companies is that the tech giants entered profit decline first in the second half of 2022. Profit decline led tech companies to cut costs earlier than other companies, thus achieving an earlier recovery. Since the beginning of the year, layoffs in the tech industry have significantly slowed down, but have increased outside the tech industry, indicating more room for cost reduction in non-tech areas. Analysts believe that cost-cutting efforts will bring better profit margin growth for the other 493 companies in 2024-25.

AI Investment is Forming a Virtuous Cycle

Bank of America Merrill Lynch stated that large tech companies (Microsoft, Amazon, Google, Meta) confirmed their view in the last quarter that 2024 will be the first year of a multi-year AI investment cycle.

During the first quarter earnings season, the consensus expectation for the 2024 capital expenditures of the four companies increased by $18 billion to around $200 billion, a year-on-year growth of 34%. Data also shows that tech investment is further accelerating, surpassing post-pandemic and work-from-home trends.

Although history indicates that companies in reinvestment cycles perform poorly, the current AI investment is forming a potential virtuous cycle. Semiconductors are the most obvious beneficiaries, as the increase in power usage and physical construction of data centers brought by AI should also lead to increased demand for electrification, construction, utilities, commodities, etc., ultimately creating more job opportunities.

Tech Stocks Holding Up Hope for Earnings Growth

The current market's more optimistic expectation is to achieve an 11% year-on-year EPS growth in the second half of the year. However, excluding the "Big Seven," the consensus expectation for sales growth is only 1%.

Although the expected 14% EPS growth in the fourth quarter looks high, over 60% of the growth (9 percentage points) comes from the "Big Seven."

Macro Headwinds, but Higher Overall Profit Expectations

Bank of America Merrill Lynch stated that U.S. companies performed strongly in the first quarter, with EPS exceeding expectations by 3%. However, since then, the macroeconomy has weakened. The Economic Surprise Index (ESI) is now at its lowest level since June 2015. Meanwhile, due to the impact of a strong U.S. dollar, foreign exchange is expected to have a negative impact of 100 basis points on U.S. corporate sales, the largest blow since the first quarter of 2023. Considering the low base of a 6% year-on-year decline in the second quarter of 2023, the current market consensus expects a 9% year-on-year growth in EPS for U.S. companies in the second quarter. **

Although macro data has just started to slow down, U.S. companies have been operating in a weak demand environment for the past two years due to the weakness in commodities/manufacturing. The number of mentions of weak demand in earnings conference calls surged in the second half of 2022, exceeding one standard deviation above the historical average for the seventh consecutive quarter. Bank of America Merrill Lynch believes that unless demand deteriorates further from here, U.S. companies have likely adapted to the weak demand environment by cutting costs and improving efficiency.

Limited Impact of Inflation

Inflation has historically been a lagging indicator of profitability. The correlation between earnings of the S&P 500 index and inflation lags five quarters for CPI and three quarters for PPI. Market pessimists believe that deflation is increasingly impacting profitability, as earnings are nominal and higher inflation drives stronger earnings growth. However, there is no statistical evidence supporting this view. While sales show strong correlations with both CPI and PPI (higher correlation with PPI), neither has any correlation with earnings growth. The highest correlation is with real GDP (i.e., demand).

Inventory Destocking Cycle Nearing End

Bank of America Merrill Lynch believes that the past 18-24 months have been one of the most severe destocking cycles in history. The decline in days of sales in inventory (DSI) of the S&P 500 index is comparable to the previous three recessions. However, DSI rebounded from its low point for the third consecutive month in June, with a year-on-year decline of 1%, indicating that the destocking cycle may be nearing its end. In addition, the ratio of ISM Manufacturing PMI new orders to inventories rebounded in June, reversing the declining trend from January to May 2024. The improvement in order trends, coupled with the continued decline in inventory levels, indicates a slowdown in the destocking cycle.