Outlook 2023 US markets: beyond the mega-caps

These companies are familiar names – Apple, Amazon, Meta Platforms (Facebook), Alphabet (owner of Google) and Microsoft plus, depending on their share prices, Tesla, Netflix or Nvidia. They share certain characteristics, such as strong franchises, powerful network effects, dominant technology and, until recently at least, fast growth in earnings. Over the five years to the end of 2021, when many of the companies' share prices peaked, they have delivered the lion’s share of growth in US markets.  During that time the mega-caps (Apple, Amazon, Alphabet, Microsoft, Meta Platforms and Tesla) returned 420%, whilst the S&P 500 excluding those mega-caps returned 108% [1].

However, many of these companies have had a year of reckoning in 2022. Their share prices have dived in response to a perfect storm

• First, their valuations were frothy and based on the assumption low interest rates would continue indefinitely. When the interest rate cycle turned, it shifted the metrics on which these companies were valued. The price-to-earnings ratio of Alphabet, for example, dropped from 25x at the start of 2022 to 17x at the end [2]
• At the same time, earnings growth slowed for many of these companies. Meta Platforms and Alphabet were exposed to a slowdown in advertising as economies weakened. Amazon was vulnerable to weakening household spending. Apple’s earnings proved resilient, but its growth was hit by the strength of the US dollar. Microsoft’s earnings were robust, thanks largely to its cloud business

Sentiment has also been important. For some time, these mega-caps have been supported by the prevailing view that their growth would endure. The significant momentum behind the share prices was difficult for investors to ignore. Investors who worried that share prices were too high or that regulatory pressures might dampen growth, had – until 2022 – missed out on stellar returns.

That said, even at the start of 2022, there were increasing concerns about the outlook for some of these companies. In our view, some of these concerns remain. There are still worries over valuation, for example. While mega-cap valuations are now at more attractive levels, and they may benefit from a pause in Federal Reserve rate rises if it comes, they remain uniquely sensitive to the economic environment. The advertising environment is likely to weaken further as recession sets in, while squeezed household incomes create a difficult backdrop for consumer spending.

Even the mighty Microsoft has seen weakness in its personal computing business. Consumer discretionary stocks, such as Amazon and Tesla have been consistent losers under Federal Reserve interest rate hikes. Amazon’s business model relies on cheap labour, which is becoming more expensive. This is a tough backdrop to maintain current growth levels.

In some cases, these companies face more acute threats to their business models. Social media giants such as Meta Platforms are facing significant regulatory threats as more research is done into the health and social problems created by their products. Meta has faced multiple million-dollar lawsuits over its privacy settings and its role in amplifying hate speech, while Amazon faces ongoing battles over its tax affairs.

Part of the popularity of many of these companies is that they offered visible growth at a time when there was little growth available elsewhere. They appeared to be hotbeds of innovation, snapping up fast-growing rivals and consolidating their positions. Other more mature companies looked dull in comparison.

This is changing. Other areas, such as some parts of the commodities market, appear to offer similar or even superior earnings growth. Rising interest rates in the US and some loosening of borrowing conditions in China should make a good environment for growth to broaden out from technology to some other areas of the market – both in the US and internationally.

Against this backdrop, we would suggest some caution on the US mega-caps. The US is a large and diverse market, with a wealth of well-run global companies. For the past decade, investors haven’t had to look much beyond the mega-caps for growth, but the rest of the market merits closer attention today. Valuations look more compelling and earnings growth may be stronger.

The key risk to this view is that interest rate rises fail to materialise or get endlessly pushed back. This would favour companies with long-term, high growth and could lead to higher share prices for the mega-caps. These companies may find amicable settlements to their legal cases and the consumer environment may turn for the better.

While these are plausible outcomes, on balance, we see the risks as skewed to the downside. After such a strong run, many investors still have large weightings in the US mega-caps and it may help the balance of their portfolios to diversify their US holdings elsewhere. It is not over for US mega-caps, but the road is likely to be more treacherous from here.

Sources:

[1] P/E ratio for Alphabet (Google) (GOOG): P/E ratio history for Alphabet (Google) from 2004 to 2022, companiesmarketcap.com [accessed 13 January 2023]

[2] Refinitiv/ Evelyn Partners