CICC: How much room is there for US stocks?

With the U.S. elections concluded, the Trump trade heating up, and U.S. stocks repeatedly hitting new highs, the performance of U.S. stocks in the third quarter has also been fully disclosed. From a performance perspective, although the technology sector remains strong, the overall growth of U.S. stocks has declined due to the drag from cyclical industries, and the market's consensus earnings expectations have also been revised downwards. However, this has not affected market performance; the U.S. stock market not only continues to hit new highs, but the strength and weakness of sectors also seem to "contradict" the aforementioned performance situation, with the cyclical-style Dow Jones even temporarily leading the growth-style Nasdaq. The main reason for this, we believe, is primarily due to the Trump trade that has heated up after the elections. Against the backdrop of significantly rising U.S. Treasury yields during the same period, the rise of the Dow Jones is more driven by valuation expansion from declining risk premiums, reflecting an early incorporation of expectations for Trump’s policies, while the Nasdaq is more supported by the earnings of the technology sector.

Chart: Valuation expansion driven by declining risk premiums is the main driver of the Dow Jones, while the earnings contribution of the Nasdaq is higher.

Source: FactSet, CICC Research Department

Chart: S&P 500 earnings adjustment sentiment overall declined in the third quarter.

Source: FactSet, CICC Research Department

The third quarter was indeed the peak of the "recession trade" in the U.S., when concerns about a recession triggered by the "Sam Rule" were clearly somewhat excessive. The U.S. economy does not face deep recession pressures, but rather a controllable slowdown; however, it is a fact that the overall economy is weakening, so it is not surprising that corporate earnings, especially those closely related to the economy, such as cyclical sectors, are slowing down. This also led to the Federal Reserve's unconventional 50bp rate cut in September.

With the rate cut in September, especially catalyzed by expectations after Trump's election, U.S. stocks have repeatedly hit new highs. On one hand, the easing of financial conditions after the rate cut can prompt the recovery of interest-sensitive real estate and investment sectors first; on the other hand, it also incorporates more favorable growth expectations post-Trump's election. At this point, the valuation of U.S. stocks (at the 94th historical percentile since 1990) and sentiment (with risk premiums at the 28th historical percentile since 1990, the lower the more exuberant) are indeed at high levels. While sentiment can be exuberant for a time, earnings are more enduring. Therefore, the key to judging the future space of U.S. stocks still lies in earnings, and the key to earnings is whether the technology sector can continue and whether cyclical sectors can restartChart: The valuation and sentiment of US stocks are both at high levels, which is a reality.

Source: Bloomberg, CICC Research Department

Q3 US Stock Earnings: Overall slowdown reflects economic downturn; cycles are the main drag, technology remains resilient, but structurally shifts from hardware to software

The earnings growth rate of the S&P 500 has overall slowed down, while the Nasdaq has accelerated thanks to "software." On a comparable basis, the S&P 500's Q3 EPS grew by 5.5% year-on-year, a significant drop from 11.7% in Q2. In contrast, the EPS of the growth-style Nasdaq index rose from 13% in Q2 to 19%.

Chart: On a comparable basis, the year-on-year growth rate of the S&P 500 index EPS in Q3 is 5.5% (vs. 11.7% in Q2)

Source: FactSet, CICC Research Department

Chart: Breaking down the performance, communication services, information technology, and consumer discretionary contributed 2, 1.8, and 1.4 ppt respectively.

Source: FactSet, CICC Research Department

Chart: In Q3, semiconductor and equipment, real estate management, etc., led in EPS growth, while technology hardware, REITs, etc., lagged behind.

Source: FactSet, CICC Research Department

Chart: Compared to the second quarter, the EPS growth rate of real estate management and development, media and entertainment in the third quarter has significantly increased, while the growth rate of technology hardware and energy has slowed down considerably.

Source: FactSet, CICC Research Department

► The year-on-year growth rate and profit contribution of cyclical sectors have both declined, with energy (-18.4% vs. 7.7% in Q2), finance (6.7% vs. 18% in Q2), utilities (5.5% vs. 16% in Q2), and industrials (-11% vs. -3% in Q2) all experiencing slower growth. The year-on-year performance of materials has slightly improved but remains negative (-5% vs. -9% in Q2). In terms of profit growth contribution, the cyclical sectors including energy, industrials, and materials collectively dragged down profits by nearly 40%, and the financial sector's contribution also declined from 31% to 24%.

► The growth and contribution of the technology sector remain resilient, but "software" outperforms "hardware." Among them, the year-on-year growth rate of media and entertainment has significantly turned positive (29.3% in Q3 vs. -8.1% in Q2), and software and services continue to rise (11% in Q3 vs. 8.7% in Q2), while the growth rates of semiconductors and equipment, as well as technology hardware, have continued to decline, falling from 57.7% and 7.2% in Q2 to 38.8% and -22.5%, respectively. In terms of profit growth contribution, the two sectors of communication services and information technology together contributed 68% of overall profits, but the profit contribution of communication services turned from -4% in Q2 to 36%, while the contribution of information technology slightly decreased from 36% in Q2 to 32%.

From the perspective of profit contribution, revenue remained largely flat, while costs increased slightly. In the third quarter, the year-on-year revenue growth rate of the S&P 500 slightly decreased from 6.4% in Q2 to 6.3%, with industries such as semiconductors and equipment, and real estate management leading in revenue growth, while energy and food and beverage sectors still have not turned positive in year-on-year revenue growth. In contrast, costs have increased: 1) The cost of main business has risen due to oil prices, with a lag of 1-2 months in the transmission of crude oil prices, leading to a year-on-year growth rate of main business costs increasing from 0.87% in Q2 to 2.1% in Q3 due to the rise in oil prices; 2) Income tax expenses have increased, with the effective tax rate rising from 12.4% in Q2 to 12.9%. 3) The decline in interest costs and selling and administrative expenses partially offset the cost pressure, benefiting from the decline in interest rates, with year-on-year growth in interest expenses decreasing from 19% in Q2 to 14%; year-on-year growth in selling and administrative expenses continued to decline from 5% in Q2 to 4%. Overall, the net profit margin in the third quarter remained basically flat (12.4% vsIn the second quarter, the leverage level decreased, asset turnover improved, and the overall ROE of the S&P 500 remained flat at 20.8%.

Chart: On a comparable basis, the S&P 500 index slightly fell to 12.4% in the third quarter, with both non-financial and non-financial non-energy net profit margins increasing.

Source: FactSet, China International Capital Corporation Research Department

Chart: On a comparable basis, the S&P 500 ROE remained flat in the third quarter; net profit margin and leverage ratio decreased, while asset turnover increased.

Source: FactSet, China International Capital Corporation Research Department

Chart: The effective tax rate of the S&P 500 in the second quarter increased compared to the previous quarter (third quarter 11.5% vs. second quarter 10.9%).

Source: FactSet, China International Capital Corporation Research Department

Chart: In the third quarter, the interest expense/EBIT (TTM) of the S&P 500 remained basically flat, while income tax/pre-tax profit increased.

Source: FactSet, China International Capital Corporation Research Department

Chart: In the third quarter, commodity prices fell year-on-year, but the main business costs of the S&P 500 increased

Source: FactSet, CICC Research Department

Chart: Wage growth has slightly rebounded, but S&P 500 selling and administrative expenses continued to decline in the third quarter.

Source: FactSet, CICC Research Department

How to view the slowdown in profits? A normal response to the economic environment, while the slowdown in the tech industry is more of a structural shift.

The decline in U.S. stock profits, especially in the economically sensitive cyclical sectors, reflects the overall economic slowdown in the third quarter. However, the market has already begun to "look ahead." The weakening of U.S. stock profits in the third quarter is not surprising, as it reflects the broader economic slowdown at that time. The manufacturing PMI has remained in contraction territory, and U.S. employment data has also continued to weaken, both of which are "microcosms" of this trend. Additionally, disturbances from extreme weather events like hurricanes, along with rising unemployment triggering concerns about a recession due to the "Sam Rule," may have affected consumer confidence and even corporate production activities.

Chart: Rising unemployment rate in the third quarter "triggers" the Sam Rule.

Source: Haver, CICC Research Department

However, the market has clearly begun to "look ahead." On one hand, the initiation of interest rate cuts helps to repair certain interest-sensitive economic segments (such as real estate and corporate investment). It was precisely the weakening of the economy and labor market in the third quarter that prompted the Federal Reserve to initiate an unconventional rate cut of 50 basis points in September. On the other hand, Trump's potential victory in the election has rekindled market expectations for a series of expansionary policies following his election (overall tax cuts, financial deregulation, increased oil and gas supply, etc.). Our calculations suggest that the natural expansion of U.S. private credit after the rate cuts, combined with the narrowing drag from government credit, will lead to a bottoming and recovery of the U.S. economy around mid-2025, with cyclical sectors likely becoming the "forerunners" of this recoveryChart: In the US social financing indicators we constructed, the year-on-year growth rates of corporate and household financing bottomed out and rebounded in January and July 2024, respectively.

Source: Haver, China International Capital Corporation Research Department

Chart: The private sector's "social financing" impulse takes about six months to affect GDP.

Source: Haver, China International Capital Corporation Research Department

Chart: Fiscal growth may remain moderate in 2025.

Source: Haver, IMF, China International Capital Corporation Research Department

Chart: Historically, in the vast majority of cases, fiscal policy has tightened in the first year after an election.

Source: Haver, China International Capital Corporation Research Department

Chart: The various segments of the US economy are "rolling" out of sync; looking ahead, the transition between "new" and "old" will first repair the interest rate-sensitive cyclical sectors.


Source: CICC Research Department

As for the slowdown in growth in the technology sector in the third quarter, it does not indicate that the overall trend has been "falsified," but rather reflects structural changes, manifested as a decline in "hardware" from a high base, while the "software" sector has filled this "gap." Although the previously strong semiconductor and equipment sectors have seen a slowdown in growth, they still maintained double-digit growth, partly due to the high base from before, while the technology hardware sector was dragged down by major weighted stock Apple. In contrast, the profitability growth of media entertainment and software services continues to rise. Additionally, the ample cash flow of technology companies continues to support share buybacks and capital expenditure activities, with the capital expenditures of seven leading technology stocks maintaining high growth in the third quarter, rising from 52% in the second quarter to 59%, contributing 24% to the overall capital expenditures of the S&P 500 excluding financials.

Chart: Operating cash flow growth in utilities, consumer discretionary, and information technology leads, while healthcare and energy lag behind.

Source: FactSet, CICC Research Department

Chart: Leading technology stocks continue to expand capital expenditure scale, with a year-on-year growth rate of 59%.

Source: FactSet, CICC Research Department

Chart: In the third quarter, the buyback scale of leading technology stocks slightly decreased to $60.6 billion, with a year-on-year growth rate slowing to 23%.

Source: FactSet, CICC Research Department

In fact, a common misconception in the market is that the surge in the Nasdaq and leading technology stocks is based on unsustainable high valuations and expectations, but on the contrary, profitability has always been the core driving force behind their rise, contributing far more than other industriesSince the beginning of the year, the rise of the Dow Jones and S&P 500 has mainly relied on valuation expansion brought about by a decrease in risk premiums, contributing 91% and 52% to their respective increases of 19% and 27%; while the rise of the Nasdaq is primarily driven by earnings contributions, with 68% of its 31% increase since the beginning of the year coming from earnings, and the contribution ratio of leading tech stocks, led by MAAMNNG, is even higher (73%). However, conversely, the decline in earnings growth in the technology sector in the third quarter also explains some investors' concerns that low growth cannot support high valuations.

Chart: The rise of the Nasdaq is primarily driven by earnings contributions, with 68% of its 31% increase since the beginning of the year coming from earnings.

Source: FactSet, CICC Research Department

Market Outlook: Expected earnings growth of 10%; short-term valuations are high, with early next year being critical for re-entry after a pullback; focus on cyclical resilience and technology as the main line

As the U.S. stock market reaches its current position, both valuations and sentiment have become elevated, and earnings will undoubtedly be the core variable determining future space. The key to earnings lies in the cyclical and technology sectors, with the former looking at economic cycles and the recovery elasticity of Trump’s policies, and the latter focusing on trends in the technology industry.

Combining the U.S. growth path (with economic stabilization and recovery gradually occurring by mid-2025) and expectations for overseas revenue growth (30-40% of overseas revenue), we estimate that U.S. stock earnings growth may reach 10% by 2025, slightly higher than this year's 9%. Of course, in our assumptions, the AI industry trend continues to maintain optimistic sentiment and high profit margins. At the same time, Trump's tax reform is expected to boost U.S. earnings by 3-4 percentage points, but whether this will be reflected in 2025 earnings will depend on the progress of policy implementation. Structurally, we focus on cyclical resilience and technology as the main line.

► First, cyclical sectors such as finance, energy, real estate, and investment mainly benefit from several aspects: 1) In the natural recovery cycle of the economy, growth momentum may experience a "new" and "old" switch, with interest rate-sensitive real estate and investment likely to recover first, but the intensity will not be too strong. We estimate that the nominal investment year-on-year growth rate will slightly increase from the current 5.9% to 8.7% by the third quarter of 2025, with real estate sales mainly driven by new homes, increasing by 6% year-on-year to around 750,000 to 800,000 units; 2) Many policies advocated by Trump also benefit more from cyclical sectors, such as under the tax reduction policy, the effective tax rates for finance, energy, and transportation are higher, thus benefiting more elastically; the interest rate cut cycle is nearing its end, and the financial deregulation advocacy of the next Treasury Secretary, Bentsen, directly benefits the financial industry; Trump's opening up of oil and gas extraction helps boost oil and gas investment, etc. Industrial giant Honeywell stated that although it remains cautious about sales growth in the short term, the company expects growth to recover and profit margins to begin expanding by 2025;Caterpillar is expected to continue benefiting from government infrastructure projects, while demand in the power generation sector will remain strong under the boost of the AI industry.

Chart: The stable increase in the number of households and the proportion of self-owned housing by 2025 may bring an incremental demand of 2 million units.

Source: Haver, CICC Research Department

Chart: Under the current sales ratio, existing homes may remain around 4 to 4.1 million units, while new home sales are expected to increase by 6% year-on-year to around 750,000 to 800,000 units.

Source: Haver, CICC Research Department

Chart: After Trump's election in 2017, the year-on-year growth rate of mining capital expenditure rose from -29% to 52%, significantly recovering for two consecutive years.

Source: Haver, CICC Research Department

Chart: The effective tax rates for utilities, biomedicine, real estate, raw materials, telecommunications services, and semiconductors are lower.

Source: FactSet, CICC Research Department

► Secondly, the trend in the technology industry remains the main line, focusing on whether AI technology can gradually be converted into revenue and whether leading companies can continue to expand their capital expenditure scale. Meta, Google, and Amazon have all stated that AI-related cloud businesses and advertising revenues benefiting from AI technology achieved impressive growth in the third quarter, and NVIDIA also stated that "the demand for large-scale enterprise artificial intelligence is still increasing."Therefore, the revenue side may still have resilience. In terms of capital expenditure, Amazon, Meta, Google, and Microsoft have all stated that they will continue to increase investments in AI infrastructure, with Amazon emphasizing that the scale will exceed that of 2024, while Google indicated that its investment growth rate may slow down.

In contrast, there is limited room for further expansion of valuations. Given the current inflation (we expect U.S. inflation to bottom out in mid-2025) and the interest rate cut path (we estimate that the Federal Reserve needs to cut rates 3-4 more times, with a terminal rate of 3.5-3.75%), we expect the reasonable central level of the 10-year U.S. Treasury yield to be around 3.8-4%. Meanwhile, the risk premium is already at the 28% historical percentile since 1990, leaving relatively limited room for further decline, and in certain cases, it may even contract. We estimate that dynamic valuations may slightly retreat to around 21, and combined with the above assumption of 10% profit growth, under the baseline scenario, we expect the S&P 500 index to be between 6300 and 6400; under the pessimistic scenario, we expect the S&P 500 index to be between 5700 and 5900.

Chart: We expect U.S. inflation CPI to be above 2% year-on-year in 2025, bottoming out in mid-year (2-2.5%)

Source: Haver, CICC Research Department

Chart: Under a soft landing scenario, the unemployment rate is not expected to rise significantly, only possibly increasing to around 5%-5.1%

Source: Haver, CICC Research Department

Chart: The appropriate federal funds rate under the equal-weighted Taylor rule is 3.1%, and the tail end of inflation at the end of the year and risks may lead to a smaller rate cut

Source: Haver, China International Capital Corporation Research Department

Chart: If the Federal Reserve stops cutting interest rates in 2025 as we predict, the neutral interest rate level for 10-year U.S. Treasuries will be 3.5%

Source: Haver, China International Capital Corporation Research Department

In terms of pace, the short-term focus is on "risks that arise from increases." After a pullback, re-entry can be considered, with January 20 being a key node after taking office. In the short term, under the sustained expectations, U.S. stock valuations are already at high levels, with many optimistic expectations factored in. Technical indicators such as overbought conditions are also continuously heating up. Therefore, if some data falls short of expectations or if the sequence and extent of policies after Trump's election do not meet expectations, it could trigger some "correction" in market sentiment. Several key nodes are: December 11, when the November U.S. inflation data is released, which may affect December's interest rate cut expectations; January 20, after Trump's inauguration, whether inflationary policies (such as tariffs and immigration) will significantly exceed expectations, and whether growth policies can meet expectations (tax cuts, oil and gas supply, etc.). Mid-January also coincides with the start of the fourth-quarter earnings season for U.S. stocks, making the market particularly sensitive. Therefore, if there are any disappointing scenarios, it could induce a certain pullback.

Chart: After taking office on January 20, inflationary policies may be quickly introduced, and growth expenditure policies may be advanced in February to March

Source: U.S. Congress, Reuters, WSJ, China International Capital Corporation Research Department

However, a market pullback is not necessarily a bad thing. First, it is necessary to digest overly exuberant emotions to facilitate a more sustainable rise. Second, the long-term outlook is not pessimistic. The strong performance of U.S. stocks over the past three years has been driven by "incidental" factors such as the pandemic and the explosion of technology and AI, which have led to significant fiscal measures, technological advancements, and global capital rebalancing, forming three "macro pillars" for the strength of U.S. stocks. This is reminiscent of the strong growth, large fiscal deficits, and trade deficits ("twin deficits") during the Reagan era, where the dollar remained strong and overseas capital continued to flow in, creating a mutually reinforcing "Reagan cycle." Many of Trump's policies may strengthen or even solidify these three pillars. Therefore, we believe that as long as these "three pillars" do not experience directional reversals, the trend of U.S. stocks may not be brokenChart: Large fiscal, technology, and global capital rebalancing are the three "macro pillars" supporting the strong performance of the U.S. economy and U.S. stocks.

Source: Haver, FactSet, EPFR, China International Capital Corporation Research Department

Chart: Expansion of fiscal and trade deficits during the Reagan economic cycle

Source: Haver, China International Capital Corporation Research Department

Chart: Significant increase in net inflows to the financial account

Source: Haver, China International Capital Corporation Research Department

Chart: In contrast, fiscal contraction occurred during the internet technology revolution

Source: Haver, China International Capital Corporation Research Department

Chart: Yet it still drives the strength of the U.S. dollar

Source: Haver, CICC Research Department

Author of this article: CICC Liu Gang Team, Source: CICC Insights, Original Title: "How Much Room Is Left for US Stocks?"

Liu Gang, CFA Analyst SAC License No.: S0080512030003 SFC CE Ref: AVH867

Yang Xuanting Analyst SAC License No.: S0080524070028

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