What To Expect When Expectations Are High

Expectations drive markets. In equity markets, stocks get valued via their price-to-earnings (PE) ratio based on the collective wisdom of the investor crowd. Stocks with high expected growth rates have high PE ratios and vice versa.

With that in mind, investors generally make the most money when they can determine where the crowd is incorrect. And that might be the case entering 2024. Many investors seem to be expecting too much from the Magnificent 7 (Apple, Microsoft, Google parent Alphabet, Amazon, Nvidia, Meta and Tesla) and other high-flying stocks of 2023. AMG expects the market leadership will probably change over the next couple of years.

Here’s why: Expected growth in earnings for the S&P 500 over the next two years has risen to roughly 11%, well above the long-term historical average of 7%. At the same time, the PE ratio for the market is very high. Most of this resurgence in growth expectation is attributable to the Magnificent 7 (Mag7). With overall growth floundering in 2022, the Mag7’s earnings outlook was nearly cut in half in some cases. But as the stocks proved resilient and prices went higher in 2023, expectations also ramped up. Mag7 stocks’ earnings are now expected to grow in the coming years at a higher rate than they did in their pre-pandemic heyday.

After a strong showing in 2023, expectations for the Mag7 are too high. Much of the Mag7 earnings outperformance last year resulted from the companies’ ability to raise prices for their goods and services as post-pandemic U.S. consumers continued spending at a fast pace. Similarly, expectations for S&P 500 earnings are elevated on the hope that the U.S. consumer will continue a rapid pace of spending unabated.

It’s doubtful the Mag7 can continue hiking prices again this year, especially if the economy and consumer slows down. The Mag7—which drive the S&P 500—are unlikely to tank; they just probably won’t repeat their 2023 outperformance.

Bottom line: So where can investors find equities with low expectations that should move higher? Small- and mid-cap U.S. stocks are likely to outperform their large-cap brethren, especially if interest rates fall later this year and in 2025, prompting U.S. economic growth to ramp up. Also, after a decade of underperformance, investors have low expectations for foreign stocks. But AMG anticipates earnings growth is likely to be appreciably higher than the past decade and drive solid returns.