Third-Quarter Earnings Are Going Well—Unless You’re Big Tech

Key Takeaways

• Third-quarter earnings look healthy, beating analyst estimates. Stocks are on track to grow profits by more than 25% for the third consecutive quarter.
• Momentum has shifted from the Magnificent Seven, which are contending with decelerating earnings growth, to the broader market.
• Strategists expect a resilient economy and lingering concerns about Big Tech’s AI investments to continue fueling a rotation away from tech stocks that began last month.

Halfway through third-quarter earnings season, analysts say results have been both strong and disappointing. Overall, earnings growth appears solid, with the notable exception of Big Tech. The divergence has amplified investor concerns about the uncertain payoff of Silicon Valley’s spending on artificial intelligence infrastructure, and raised questions about whether the market is in an earnings bubble on the verge of popping. It has also fueled a stock rotation that has markets treading water, but which strategists say could set investors up for more sustainable gains.

As of Oct. 30, with 60% of the S&P 500 having reported, companies were beating estimates at an above-average rate, but those beats were leaner than in recent years, according to FactSet. In aggregate, the S&P 500 has topped estimates by 1.9%—the smallest positive surprise since the fourth quarter of 2022. Revenue trends also point to a more challenging environment, with the share and magnitude of S&P 500 top-line beats both trailing their one-year averages.

“When we look at the aggregate numbers, [they’re] still pretty solid,” says Michael Arone, chief investment strategist for State Street Investment Management. “Below the surface, some things suggest expectations were very high, and companies are struggling with beating those expectations.”

Companies beating estimates have seen above-average share price increases, while those missing have seen below-average declines, according to FactSet. Nonetheless, “the market has largely taken this in stride,” says Arone. The Morningstar US Large Cap Value Index has risen nearly 6% in the last month, cushioning the blow from the Large Cap Growth Index’s almost 7% decline. In all, stocks are little changed, with the Morningstar US Total Market Index down about 1% so far this quarter.

AI Jitters Weigh on Hyperscalers

While the overall stock market has not moved much since earnings season began, a few prominent companies have been severely punished for falling short of expectations. Analysts entered earnings season expecting to see cloud revenue growth accelerating for all the hyperscalers with cloud businesses—Alphabet GOOG/GOOGL, Microsoft MSFT, and Amazon AMZN—and stable growth in their core businesses. Investors consistently got the former but not the latter.

Alphabet stock had its worst day on record last week, after the company reported revenue growth in its core search business slowed to 12%, compared with Wall Street’s estimate of nearly 15% growth. Tech stocks sold off on Friday after Amazon missed revenue estimates. Shares of Meta Platforms META and Microsoft also fell after their earnings came broadly in line with expectations.

“It’s almost a no-win situation for the Magnificent Seven in a lot of ways, because they’re experiencing impossible comparisons to peak earnings growth rates,” says Gina Martin Adams, chief market strategist for HB Wealth.

The Magnificent Seven—Nvidia NVDA, Apple AAPL, Microsoft, Alphabet, Amazon, Meta, and Tesla TSLA—have reported faster aggregate earnings growth than the remainder of the S&P 500 in every quarter since the end of 2022, but the rest of the index may finally be catching up. After last week’s disappointing reports, the Mag 7 are on track to grow profits by 29% in the third quarter, compared with 33.6% for the rest of the S&P 500, according to FactSet. (Mag 7 estimates are a blend of the actual earnings growth of the six companies that have reported and the estimated growth of Nvidia, which reports on Nov. 17.) The index as a whole is on track to report third-quarter earnings growth of 31.3%, topping analyst estimates of 29.1% at the end of the quarter.

Analysts say the Mag 7’s earnings were affected by some one-time headwinds. Alphabet’s quarterly profit was artificially depressed by a nearly $9 billion decline in the value of its equity portfolio, while Meta’s earnings were negatively impacted by a one-off $10 billion legal charge.

Investors are also focused on the group’s massive capital expenditures, which have turned once-robust quarterly free cash flows negative. That cash burn has forced tech giants to slow or stop share repurchases and raise fresh capital in equity and debt markets, diluting existing shareholders and increasing the firm’s cost of capital. Even Microsoft, the sole hyperscaler still reporting positive free cash flows, announced last week that it plans to sell $25 billion of bonds in its first debt issuance since 2017.

Investors are demanding that hyperscalers demonstrate their AI spending is paying off, and their most recent reports may have disappointed on that front. Alphabet’s search revenue miss was partly due to the lower monetization rate of AI Mode searches compared with conventional search. The hyperscalers’ incremental margins have declined by more than 12 percentage points over the past four quarters to about 28%, according to strategists at BlackRock Investment Institute. “In other words, each additional dollar of revenue is generating less additional profit,” the strategists wrote.

Broad Earnings Growth Seen Supporting Broad Stock Market Gains

AI-specific concerns have compounded the drag on share prices from worries about “peak earnings,” which investors often view as “a warning sign that the good times are ending,” says Jeffrey Schulze, head investment strategist at Franklin Templeton Investment Institute. “Consensus suggests that peak EPS growth is upon us,” says Schulze, but “history shows that the peak itself is less important than where earnings settle afterward.”

Since 1980, the S&P 500 has returned nearly 20% on average the year after earnings growth peaked when growth remained above 10%, compared with a 6% return when growth fell below 10%. Over the next year, earnings growth is expected to slow from 30% to about 19%—a strong pace that analysts expect to be more evenly distributed than the mega-cap-tech-led economy of recent years.

Strategists say the narrowing gap in stock performance between mega-cap tech and the rest of the market also bodes well for future returns. In the past month, the equal-weight S&P 500 rose about 5%, while the capitalization-weighted index slid 2%.

“I’d be more concerned if there were indiscriminate selling based on what’s been happening in the technology sector, but so far, that’s not the case,” says State Street’s Arone. “Investors are recognizing the fact that, despite some of the headlines, the economy is expanding and earnings, even beyond tech, are growing solidly.”