Market is not narrowly driven by megacaps: Petursson

Key Concepts

• Broad Participation in Earnings: Earnings growth is widespread across sectors, not concentrated in a few large companies.
• Revenue Growth: Companies are increasing earnings through higher revenues, not just cost-cutting.
• MAG 7: A group of seven large-cap technology stocks whose performance has been significant but not universally dominant this earnings season.
• Earnings Surprises: The percentage of companies exceeding analyst expectations, and the magnitude of those beats.
• Forward PE Ratio: A valuation metric indicating the price of a stock relative to its future earnings.
• Federal Reserve Interest Rate Cuts: Projections for future reductions in the federal funds rate.
• Inflation Moderation: The expected decrease in the rate of inflation.
• US Government Debt and Tariffs: The impact of tariffs on government finances and the broader economy.
• Economic Growth (US and Canada): Projections for GDP growth in both countries.
• Recession Risk: The likelihood of an economic downturn.
• Canadian Market Value: The attractiveness of Canadian equities for investment.
• TSX: The Toronto Stock Exchange Composite Index.

Earnings Season Performance

The recent earnings season has been characterized by broad participation, meaning earnings growth was observed across a wide range of sectors, not just a few dominant companies. This strength is not solely attributed to cost-cutting or margin expansion; revenue growth is also a significant contributor, which is viewed as a positive indicator for the outlook into 2026.

MAG 7 Performance vs. Broader Market

Contrary to a narrative of sole dominance, the MAG 7 stocks have not all performed at the top of every list. As of the end of October, Nvidia was ranked 36th or 37th best performer for the year. Within the top 100 performers, only two MAG 7 stocks were present: Nvidia and Google. The next 100 performers included three MAG 7 stocks, with a few others appearing beyond that. This indicates that numerous other companies have achieved exceptional performance, although the market capitalization weighting of the MAG 7 has skewed overall market participation towards them.

Earnings Surprises and Market Reaction

For the broad S&P 500, earnings surprises were around 7%, which is consistent with historical norms. However, a notable point is that 82% of companies surprised to the upside, a figure higher than the historical average of approximately 70%. This trend of increasing upside surprises has been observed over the past couple of years, partly due to companies becoming adept at managing analyst expectations.

Despite these positive surprises, there were no significant jumps in stock prices following upside earnings announcements this quarter. This is attributed to much of the positive news being priced in beforehand, with expectations for significant beats already factored into valuations. The market is viewed as a game of incremental gains rather than large, immediate price movements.

Valuation and Forward Outlook

The US market's forward PE ratio is approximately 23 times. While this appears high when viewed in isolation and is at the top end of the 20-year range for the S&P 500, it needs to be considered within a broader context. This valuation is supported by strong earnings growth, robust revenue growth, and continuing profit margin expansion.

Furthermore, the outlook is positive due to anticipated Federal Reserve interest rate cuts and moderating inflation. These factors are expected to be positive for valuations.

Federal Reserve and Interest Rates

The projection is for the Federal Reserve to implement approximately four rate cuts between now and the end of September next year, bringing the Fed funds rate down to 3%. This level is considered reasonable, especially if inflation settles around 2.5% through 2026. The Fed is not expected to be under pressure to reduce rates further to 2%.

US Government Debt and Tariffs

The US government debt remains an overhang. While tariffs are expected to contribute a small amount to addressing the deficit, their impact is considered minimal in absolute terms. The potential for increased deficit spending, for instance, through direct payments to citizens, could negate any gains from tariffs. Tariffs are described as a "robbing Peter to pay Paul" strategy, not considered good economic policy and unlikely to reduce the deficit.

Economic Growth and Recession Risk

The US economy is growing well, trending at about 3% growth. Canada's growth is expected to be weaker. Overall, these conditions suggest a favorable economic environment with a low risk of recession. The Federal Reserve is expected to cut rates due to a softening labor market, but it is not anticipated to reach a recessionary level where unemployment spikes above 5%.

Canadian Market Attractiveness

Canada is seen as offering great value for asset allocation, even more so than the US. The Canadian market environment is considered attractive, with oil producers being cheap, gold producers benefiting from gold price gains, and banks being reasonably valued while generating strong earnings growth. These factors are positive for the TSX going forward.

Conclusion

The earnings season has demonstrated broad-based strength driven by revenue growth, not just cost-cutting. While the MAG 7 have been significant, other companies have also performed well. Despite high valuations, the market outlook is supported by strong fundamentals and anticipated interest rate cuts and moderating inflation. Canada presents a particularly attractive investment opportunity due to the undervalued nature of its key sectors. The overall economic environment suggests low recession risk.