A Year-End Rally Could Double The S&P 500's Gain This Year
Summary
Market Outlook: The podcast discusses the potential for a year-end rally in the S&P 500, emphasizing the strong earnings performance in recent quarters, particularly in Q1 and Q2 of 2023, which had the best earnings beat percentages since 2021.
Sector Performance: The improvement in the S&P 500's net profitability is attributed not only to the tech sector but also to financials, utilities, industrials, and materials, indicating a broader market strength beyond just technology.
Valuation Concerns: The Schiller PE ratio is highlighted, with a discussion on how current high valuations might not be as alarming when considering the improved earnings power of the S&P 500 over the last five years.
Financial Sector Insights: Financials are experiencing net profit margin expansion, which is unusual outside of a recessionary recovery, suggesting a mid-cycle economic environment.
Utilities Sector: The utilities sector has undergone a significant rerating, becoming a growth story with higher profit growth, which is rare and noteworthy in the current market context.
Seasonality Trends: Historically, the S&P 500 peaks in Q4, with December being the most common month for annual highs, suggesting potential for further gains as the year closes.
Big Tech Financial Analysis: The podcast examines the cash flow and capital expenditures of major tech companies, highlighting their substantial cash generation and investment in AI, which is largely sustainable due to strong underlying cash flows.
Investment Takeaway: The discussion concludes with a bullish outlook on US large-cap equities, viewing any near-term weakness as a buying opportunity ahead of a potential year-end rally.
Transcript
Ladies and gentlemen, today's show is brought to you by Vanguard. To all the financial adviserss listening, let's talk bonds for a minute. Capturing value in fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds actively managed by a 200 person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So, if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com/audio. [Music] That's vanguard.com/audio. All investing is subject to risk. Vanguard Marketing Corporation distributor Compound Nation. It's the return of Nick and Jessica. I am so excited. Uh, welcome back to What Did We Learn? Uh Nicolas and Jessica Ray are the co-founders of Data Trek Research and the authors of Datrex's morning briefing newsletter which goes out daily to over 1500 institutional and retail clients. Dick and Jessica also have their own YouTube channel which you can find a link to in the description below. Guys, it's so good to see you again. Uh hope all is well. Hope you're getting ready with your Halloween costumes, I guess. What What are we going to be this year? The Vicks. What? What are we thinking? >> Oh golly, the Vix is a great idea. >> How would you do it? How would you do it? You'd have to invent like some sort of VIX creature, I suppose. I don't know. Be a tough one. >> Something asleep for a long time and then it comes up and becomes a monster. >> Yeah, I I suppose. I suppose. All right. Um, we're going to talk about the uh uh the earnings power of the S&P 500, which very appropo to the moment that we're in. This is yet another very I'm this is me my me editorializing. You guys tell me if you agree. I believe that this is yet another very good um quarter worth of earnings with the caveat that we ain't seen nothing yet. Um all the big technology companies are still to come uh very quickly. But if you were just to judge it on what we've seen so far, it's uh I think a sigh of relief and I think it justifies some of at least the rally that we've been enjoying since the summer. What do you guys think about that? >> Yeah, that seems totally fair. Um it's, you know, it's still early early days though. You don't don't want to prejudge too much. >> I I Well, I agree. That's why you're here. Okay. Um you guys say the key to understanding Q3 uh reporting season and valuations can be found in this chart. I'm just going to let you cook. I want to hear what you think. >> Cool. Let's throw up the first chart. This chart shows, it's a fact set chart and it shows by how much the S&P 500 companies beat earnings expectations over the last 5 years. And on the left hand side of the chart, you can see during 21 they were huge beats because nobody thought companies could make as much as they did. So like 14% beat percentages. So if a company was expected to report a buck, they reported a buck 14. Just tremendous. went through kind of a slog in 22. It slowed down a lot and then it picked up again during the current bull market 23 24 and the first half of 25 those two quarters Q1 and Q2 actually had the best earnings beat percentages since 2021. So 8.1 and 79% I think so we were coming off of two quarters of extremely strong earnings beats and right now for the through the last week we're like 5.9%. So, it's pretty good. But the issue is companies, you know, basically didn't really die down this quarter. So, analysts didn't take their numbers down this quarter. So, analysts actually left their numbers unchanged because they gotten beaten so bad in the first two quarters. So, expectations are quite high right now. >> Can we put that chart back up? I want to ask you, so just for the the listener who's not looking at the chart at this moment, we're not saying the percentage of companies that beat. That's a totally different um data series. We're saying the the the amount that earnings were above expectations. So, not the beat rate, but like literally what percentage companies were beating by. And to Nick's point, in Q1, they they beat by 8.1%, which is fantastic. The following quarter, 7.6, but now with a lower beat rate, at least so far. Uh, Nick, I think what you're saying is the analysts aren't getting sandbagged anymore. They're not they're not going to they're not going to play that game where uh you know they they allow their coverage universe to come in and crush their expectations by 20 cents a share. So it's like it's like everyone has now figured out that earnings are going to remain strong which lowers the nominal beat rate uh nominal beat percentage. >> Correct. You know and it's it's it's fine news. It's not anything to be to be worried about. It's just I wanted to point out that the first two quarters were extremely strong and that's goes to a lot of why the market's been strong. Uh perhaps we can just flip over to the next chart because this is Jessica's explanation of how things are going by profit margin by c by um by sector. >> Sure. Yeah. Uh the point here is that it's not just tech improving the S&P 500's overall net profitability. So as a baseline fax faxet expects the S&P 500 to post a 12.8% 8% net margin in Q3 2025, which is a 0.3 point gain from last year's third quarter. And that's also close to the all-time quarterly high of 13.1% in uh 2021. Um, so this chart shows which sectors have contributed to this increase in net profitability. And we also added our notations of each group's year-over-year change in net margins in green to mark a positive comp and red to note a negative comp. And I have just three quick points on this data. The S&P's year-over-year expected net margin improvement for this quarter is due to five out of the index's 11 sectors with financials adding the most at 1.7 points, followed by technology and utilities at 1 and a.5 points each. And then industrials and materials at 0.5 and 0.8 points. And then there's two sectors that are expected to keep net margins relatively stable at0.2. two points for energy and negative0.4 points for consumer staples. And lastly, four sectors are expected to see me meaningful net margin contraction anywhere from down 0.6 to one full point and these are real estate, communication services, consumer discretionary and healthcare. So the upshot here is that while tech has led to higher expected margin improvement for US large caps over this quarter versus a year ago, there's still four other S&P sectors that have also helped. So this shows that this isn't just a tech phenomenon and we think helps support high valuations here since margin expansion should continue with many S&P sectors contributing. >> I want to ask you about two of these sectors, utilities and financials. Um, let's let's do financials first. Uh, chart off for a second, guys. So, a net profit margin expansion uh year-over-year in this quarter um of plus 1.7%. That's really meaningful. These are this is like I don't know trillion dollars worth of market cap or or or $2 trillion worth of market cap. JP Morgan is like 800 billion by itself. So, let's just assume like we're talking about really big companies that are not semiconductors or software. And um I guess my question would be I don't know if you have the data at your fingertips. It would probably be really rare to find a bare market where uh financial companies were expanding margins. That probably never happens. Now, it probably does happen coming out of recessions. >> Yeah. >> Okay. But that's not the situation that we're really in right now. So it kind of feels midcycle when you just think about like financials having that ability to grow profitability. And I know it's a really unique set of circumstances like uh you know longer longer rates holding up, shorter rates finally coming down, a lot of pent up you know things happening in housing etc. But like for me, if you ask me like when would you see financials expanding margins? The last answer I would give you is in a downturn or or I I don't know. It just feels like this should coincide with a continuation of a bull market. Am I extrapolating too much? >> No, we'd agree with you. >> Okay. Utilities has to be the story of the year. Has to be this. This is I've never seen anything like this. The utilities as a group have undergone this insane rerating. They've become growth companies. I believe that they are the top performing sector on the year. They're so small they don't even move the needle for the overall S&P. And then also I think they have higher profit growth than uh technology as a sector. Do I have that right? >> Uh we have to go back and check. That that sounds aggressive. On all the facts side charts, it shows up as less, but perhaps it's a subset of that of that group. >> Okay. All right. I saw something like that where profit growth for the utilities was higher than something. Maybe it's not the tech sector. Um what do you guys think of what do you think? What do you guys think of um that story? I know there it's a small category of stocks >> in the overall markets. I know it's not terribly important to what the S&P does, but it's got to be something that I think is is bolstering the case for a broader rally than, you know, what people would have given us credit for on the surface. >> Well, you've got a couple of things. You've got obviously the tech story and then you've got rates coming down. So, you've got the two things that could really drive both secular demand and then demand for the stocks because the stocks are kind of dividend yield plays. Now, interestingly, consumer staples have not done well this year. So, the yield play itself has not been enough. But you're right, as an old cyclical analyst, I mean, I covered the autos in the 90s. To see a group like utilities get rerated like this really is a, as you alluded to, almost a historic uh event, something that you only see once or twice in your career, and this is happening now. >> Okay. Um, it's really hard to predict whether or not this can continue. Um, I'm just curious when people ask you guys about the utility sector. By now, most growth managers own a bunch of these in their portfolios. Um, probably getting questions about companies that you forgot even were publicly traded. U, these are not bonds anymore. They used to be. Um, so how how do you how do you think about whether or not there are forward-looking opportunities in the space? Is it just about capex and AI electricity demand holding up >> in the short term? Yes. Yes. That's the story that's got to keep it together. You know, it's look, the way we tell clients is it's a better group for for yield than consumer staples. It has a better growth profile. So, it still fits into the yield category, but with a more of a growth bent. >> Okay. Um, all right, let's continue. What's next? >> Next chart. Now, expanding the conversation about earnings, something about valuation. Let's go to the Schiller PE. This is the scary chart that everybody looks at every single day and it shows the Schiller PE which is the based on 10-year average trailing historical earnings. So if you earned if the S&P earned $100 on average over the last 10 years trades for a,000 it's P's shoulder P's 10. Right now we're trading at 39 almost 40 and that's levels we haven't seen since the.com bubble. That's the bump in the middle of the table or the chart. And so we're very very high historic valuations. And this chart bothers a lot of people. So let me flip over to the next chart and kind of try to explain it away a little bit. This shows you S&P earnings by year. Um earnings per share by year. And the current, you know, 39 multiple on the Schiller PE is $167 a share. That's the normalized earnings from which we derive that's 39 Schiller PE. However, the >> you're averaging the earnings per share over the last 10 years to come up with what did you say? 67. >> Correct. >> And now if you look at the last 5 years, 21 to 25, the average S&P EPS is 232 a share. So it's 39 40% better. So I think a problem with the Schiller PE is that we're still using earnings numbers from a long time ago, literally from the mid2010s, where earnings power for the S&P has improved materially since then. Margins are better. Uh revenue growth has been good. And so if you're looking at just the last five years of of of earnings, the Schiller P is more like 28 29, a much more reasonable number. So I don't want to overly excuse high valuations, but I did want to point out that the earnings power of the S&P I think is closer to 230 than 160, 170, 180. And if that's the spirit of the Schiller PE, then its actual number is actually quite a bit lower and it's not as worrisome as that first chart would indicate. It's so funny because 10 years ago when you're saying companies now are materially more profitable and things have changed even 10 years ago and prior like from the from 2012 to 2015 this Schiller cape ratio stuff really got a lot of attention in the markets and it was one of the primary things that people used to keep other people from investing in stocks and they pointed at the year 2000 and they said here we go again and Michael Batnik and and I were talking about this the other day. We we were writing I don't know dozens of blog posts just obliterating the Schiller PE. Not that we don't think there's validity in in looking at long-term averages, but like oh my god, you want to compare Amazon and Apple today versus Bethlehem Steel? Like is it is is this an exercise that's helpful to anyone? It's different stocks. >> Yeah. Forget forget about higher forget about like systematically higher profitability. It's just different companies. If it were like companies and we were saying today's IBM versus IBM in 1985, all right, I'll pay attention somewhat. Um, but I I I kind of find like this whole exercise, it's it's like um it's like thinking about an NBA player in the 1970s and dropping them into the NBA of 2025. >> Like what is the likelihood that that player would would even be able to function in the middle of the court? So, um I don't know. I maybe that's overly dismissive or overly generalizing, but I just think companies are better today at being companies than they were uh 50 years ago. What What do you think about that? >> Well, I'd also say that the top seven companies that are a third of the S&P are really, really good companies with amazing cash flows. And we'll get to this in the third section of the video, but these are amazing companies that are at the top of the stack and they dominate the top of the stack. They're a third of the entire index, those seven names. And so it's not just they're great companies, it's that they're great companies with a lot of weight in the index. >> If you if you guys had to worry about one or the other, I think I know the answer, but which would it be? Worry about valuation on earnings or worry about whether or not earnings growth will continue. >> I sort of think the latter is the thing that's going to decide whether or not stocks can go up and not the former. Like all of a sudden everyone's going to decide, oh, these are too expensive. I like I think they won't do that until earnings growth goes away. >> Yeah. As long as earnings growth supports valuations, it can continue. >> Even ele even elevated. I'd rather buy I guess the way I would phrase it is I'd rather buy an expensive stock market with earnings growth than a cheap stock market without >> and two the lesson from 2000 is you want to buy a market where the Fed's not raising rates because that's what really tipped over the Apple card in April and and May and June and and really cracked the dot bubble. first big crack in the NASDAQ was right after March and it was because of the fact that the Fed was beginning to raise rates again and no one knew how high they would have to go and so that was really the the catalyst. So I just want to layer on the macro side to to the argument but I think you're right. >> Okay. Um what are we saying here? Uh the 24 times consensus estimate for 2026 of 304 a share is 9% upside from here. Why is that important for people to keep in mind? It's important because the S&P valuations over the last call it decade had run from 14 to 22 times. 14 at the trough, 22 at the peak. Um that's been the formula. In order to get a reasonable buy target like 9% up for the S&P, you got to go out to 26. You got to believe in 304 a share which is about 14% growth from this year. That's the fact consensus number. So it's it's fine. It's the Wall Street consensus number. But you got to put a 24 multiple on that. You got to be be comfortable putting a 24 multiple on this market to generate a reasonable S&P upside from here, 9%. If you can't get there, it's probably a tough market to rationalize. We personally think it it merits 24 times, but it's a big number. It's a chunky number. What are the mental gymnastics for us to all be comfortable at 24 times? like what did you guys have to bum I assume we're baking in easier monetary policy continued deregulation um I don't know what like what else do we have to throw into the mix global economic growth >> no I I mean I this is a little bit fil but I really believe it's true you have to absorb the concept of a third of the S&P having a 50 to 60% ROE and that's the big tech names you have to absorb the fact that is materially different from any market we've had four and these companies not only dominate on ROE and return on capital but on the next phase of tech growth which is obviously AI so I think it's the realization that these are truly unique times this time actually may be a little bit different for a while not forever but for a while uh Dr. Ra, do you concur? >> Yes. >> Okay. I assumed you did. All right. Uh let's let's talk seasonality. >> Sure. So, back when we were on in June, uh the peak for the S&P for the year was in February. And we said that was unlikely to be uh this year's high despite the trade shock because it's only happened one other time since 1980. And that was uh that one time was in 1994 when the Fed aggressively hiked uh rates throughout the year. No, no transparency had ahead of that hiking cycle. And our upshot was that the odds are much higher for a Q4 peak barring an exogenous shock when annual returns are usually up by double digits. So um fast forward to now and that turned out to be correct with uh now the S&P's current peak for the year being October 8th. Um, so the table you just had up shows you uh back in June um shows you uh the number of times the S&P has reached its high for we showed you this back in June. Um it shows the number of times the S&P has reached its high for the year and each month back to 1980 along with the average annual returns for each of those uh 12 instances. So, I have just four quick points here. And the first is that the S&P has peaked for the year almost three quarters, 71% of the time in Q4 over the last four and a half decades. So, this year's October 8th high so far is in keeping with those historical norms. And the reason is because US equities usually post annual gains, doing so 82% of the time from 1980 through 2024. And the highs for the year tend to come in Q4 because the S&P has been rallying through the year. And then the second is just that the S&P has always had a positive annual return a total annual return when it has peaked for the year in Q4 and typically by strong double digits up an average of anywhere from 19 to 22%. And when the S&P's high for the year was in Q4, it had positive total uh doubledigit returns, annual returns of 88% of the time, 28 out of 32 years. In the remaining four years, there it was up anywhere from 5 to 8%. So the S&P is currently up 13.3%. So again, that is in keeping with historical norms. And then >> are you saying it's it's a typical year then? >> Yeah, it is. is actually is a pretty typical possible. >> We never think it's typical when we're in it. >> We never like we never nobody would say, "Yeah, this feels normal, but like it's fairly normal what's going on. >> It is." And um but I would just say for the peep being in October that that's a good segue to the third point here. It's that the S&P has actually only peaked though for the year and this is good news for investors. It's really only peaked for the year in October four times since 1980 or less than 10% of the times and those were in uh mostly in the 1980s uh 1983 88 89 and 2007 with an average annual total return of positive 19% ranging from 31 a.5% and 89 to 2007's 5.5% just before um the great uh the great recession. And then the S&P has also only peaked in November uh four times since 1980 as well. Uh also just 9% of the time and those were also mostly in the 1980s uh probably from uh mutual fund uh year ends from um tax laws selling. Um, so I was in 1980, 82, 84, and lastly 1996. And these four years also had an average annual total return of 20% ranging from 6.1% in 84 to 31% uh 31.7% in 1980. But really the the point here is that the S&P has peaked for the year in December 53% of the time back to 1980. the average total return was positive 22%. So given that the first nine months of the year are over, the odds that the S&P peaks in this month or next is 12 1.5% each, while the chances of the index topping out in December are 75%. So, the takeaway here is that with just three months left to finish this year, the S&P has much higher chances of topping out in December, 75% odds, rather than this month or next. And the index would still have to nearly double to meet the average performance of when the S&P does peak in December. Again, an average of 22% a 22% total annual return. So, has plenty of runway left. So overall um we remain bullish on US large cap equities through year end and see any near-term incremental weakness as buying opportunities before that year end melt up. >> So if if the if the if this the typicalness of this year holds up there could be a lot more gas in the tank to get us into the end of the year just to do like an average you know December high. Um, why do you thinkif Why do you think the market makes its high for the year 53% of the time in the month of December? What what's the is there like an anthropological reason for that? Is it is it people that have earned money all year? That's like when they want to get it fully invested before they go away for Christmas. Is it structural? Is it mechanical? What what do you think is behind that? Yeah, it's just that the the the S&P 500 is usually up most of the time and uh and it rallies throughout the year. So, it tends to uh melt up into into uh throughout December. >> Okay, Nick, what do you think about that? >> Yeah, know I think it's fair. I think that's, you know, that's statistically how how it works out. You know, I also think that, you know, come to the end of the year, if it's been an up year, you get a little juice at the end of the year from two effects. The first is just people putting money to work at the very end of the year just for year end showing people that they were invested. And secondly, there's always this big drop involved at the end of the year as options desks take off positions in the final week to not show a lot of a lot of exposure on the balance sheet of banks or brokerage firms >> and you get a bit of melt up too. I think there's some career risk stuff going on and just people that maybe are trailing the index, they get a little bit more aggressive into year end, try to make something happen for themselves as far as like window dressing. Like look, I did own Broadcom. I was in these stocks. I think there's always some of that um which we call it a performance chase or whatever, but like uh I I know from talking to people that it's real. Um, I also think buybacks, which no one's talking about anymore, so we're in this like blackout period with earnings, but when we come out of this period of earnings, you're going to see the buybacks resume again. And I do think that there's, you know, corporations want to get a lot of that done so that when they're reporting Q4 earnings in January and February, um, it's helping their earnings per share. Um, you know, I do think they want to shrink uh shrink the the share count going into year end. And this year, like many years before it, there are a lot of resources at the disposal of these companies. They've made tons of money all year. And I think this is uh I think the buybacks are the thing that like get us going in November um once we get through the big tech earnings. I don't know. Do you think this there's something to that effect at the end of the year? >> That feels right. Yeah. This year for sure. I mean it all depends on how how strong earnings are but yes. >> Okay. Um what's the third thing that we want to do today? Uh >> financial analysis on big tech. >> Yeah. This is a little bit grimy but I thought it's really important because this is ultimately the conversation that the market is having right now and it breaks down into two questions. The first is how much money does big tech actually make and where does it go? Like how much is going into capex and then what's the actual required return on that investment. So the first table and apologies it's going to be bit of an eye chart but the first table shows you the cash flow from operations for the big five companies the big five hyperscalers Microsoft Nvidia Amazon Alphabet and Meta so it shows you cash flow from operations last year and the first half of this year it shows you capex which is the money going into hyperscaling and then buybacks and dividends and it basically breaks down how much of the cash flow from each company goes to those end uses investing in the company capex or handing money back to shareholders by buybacks and dividends. And a couple of big points on this. First, we're not including Apple in this by the way, uh because they're not really an AI hyperscaler, but just these five companies, Microsoft, Nvidia, Amazon, Alphabet, Meta, are generating about $570 billion in cash flow this year. Operating >> Oh, is that all? >> Yeah. Exactly. Exactly. It's like most of the way to a capitalization of JP Morgan. I mean, it's just a mammoth number and people forget that sometimes of that. >> Mick, is that I'm sorry. Is that versus 38 billion a year ago? Can that be true? >> No, it is versus 532 the year ago. >> What's the 38 then? >> The change from last year. >> The change. Okay. All right. >> So, it's 570 up from up 38 billion from the prior year. So, >> perfect. over half a trillion dollars of operating cash flow. This is just straight off the cash flow statement from the the financial statements. Of that 570, about 325 is going into capex. So they have more than enough money to cover the capex budget. And they're still buying back in aggregate about 170 billion in stock and paying out 40 41 billion in dividends. So it's a big misconception that they're plowing all their money into capex. There's still money going back to shareholders. And more importantly, the companies have tremendous operating cash flow. If you were going to add Apple to this, it would add another hundred billion dollars of operating cash flow. >> I was going to say you might have to you might have to do you might have to include Oracle uh next time you do this. >> Yes. Yes. It's a it's a a late a late arrival to the story. One last thing I'd point out is just the way companies spend their money is very different. So Nvidia for example spends almost nothing on capex 5 to 7% and it buys back you know it buys back almost it buys back with its cash flow roughly from half its cash flow. Amazon is the only big tech company left with no dividend and no buyback. So it all goes to capex which is kind of nuts. It's the last pure play you know old school tech name with no buybacks and and no dividends. >> That really is that really look how it sticks out. That really is amazing. I've never seen it I've never seen this stuff laid out this way um with Amazon compared to the others. There is zero attempt to return capital. They just I guess they see the investing opportunity as so much bigger than the opportunity to shrink the share count. >> Yes. I've often thought if I had to cover one of these companies uh as a single stock analyst, the last one I want to cover is Amazon because there is nothing that leaves that shop. the money just stays in that machine and just keeps circulating back and forth. It's It is amazing. It is amazing that that company of that size with, you know, that kind of cash flow, roughly a hundred billion dollars of cash flow, >> is still reinvesting all of it. >> Um the last chart, last table I'll just show you. This is even a little bit griier, but I'll try to summarize it for you. >> This is an attempt to understand how much these companies have to make an incremental cash flow based on the capex that they're putting to work. So if you put in, and this is a very simple corporate finance calculation. So if you put a hundred billion dollars of cash flow to work in a project, you're going to want to see at least a 15% return because that's going to be, you know, the what your return for your your shareholders is. That's being a good steward of capital. And so what I've done is just take the capex budgets, figure out a 15% return on investment, and then work out how much incremental cash flow the companies have to generate to justify the capex that we talked about in the prior in the prior table. And the answers vary, but they're not very high. Amazon, because it reinvests so much, has to generate a 30% return on its capex, but the rest are between 2 and 12 and 15 and 15%. So these companies are so big and generate so much cash flow that they actually could justify their capex investments in Gen AI just with the growth of their organic businesses. So it's a you know people are saying oh when's when's the when's the you know so and so going to hit the fan from all this investment. And the short answer is they're so profitable and generate so much cash flow that we're not going to know for a couple of years at least if this capex and genai actually quote paid off because the underlying cash flows are so strong. I think there are journalists out there who are on the hunt for evidence from internal like documents and memos about concerns within these companies about the levels of spending and the lack of quote unquote ROI on the spending. And it's almost it's almost become like a subgenre of technology journalism is Microsoft is worried that blank or Oracle um executives privately are concerned with I I understand the impulse. It's a really hot story. If and when one of the hyperscalers decides they're pulling back the reins, it has massive ramifications for everyone and everything. So, I understand why the reporters want to be the ones that break that story. I think there's also like a degree of shade and freud um because a lot of people that have missed out on the AI trade, a lot of investors, they want to believe that it's not true and that they couldn't have been mistaken by not owning Nvidia because it's all fake anyway. So, there's that component of the disbelief of these capex numbers. So, I I do think that there are a lot of people rooting for this to end, but to your point, most of this spending coming out of cash flow and you know, like most of this capex spending, it doesn't appear to be the type that's unsustainable. It the numbers are huge, but the cash flows are there to back it. Is that what your table is is proving? >> Yes. And more than anything, this isn't an an analytical point. when you're trying to identify marginal returns on capital for a company, you ultimately only can use the baseline numbers from the entire cash flow statement. So, we don't have the internal ROIs on these new projects. All we can do is judge the aggregate numbers. And by the aggregate numbers, you don't have to generate that much more cash flow to justify these investments because the underlying cash flows are so strong. So, it's going to be hard from as a financial analyst to say, "Aha, Microsoft's ROI went from 15 to 2% in a year because the u the capex for AI didn't pay off." It's it's not going to happen that way. >> Yeah. And because Amazon's a great example, but all of them to some extent, it's a little bit of a black box. The money is fungeable. You don't actually know which dollars are being allocated to what. to your point, you have the aggregate numbers, but you don't know individual projects, which one is very profitable, which one's not profitable at all. Um, nobody really has visibility into that other than people inside of the company in the CFO's office. So, it's really hard to you I guess you could look at the aggregate and make a judgment on the overall company's spending and what did it return, but you don't know which specific AI projects are quote unquote good versus bad. There's some element to that. Right. >> Right. Look, I mean, if you wanted to tell a really negative story about this entire environment, I touched on this last week for clients, and I don't want to make too much of it, but I want to bring it up. We know a lot about where all this money is coming from and where it's going, right? But here's a simple question. Who audits OpenAI? >> Who's the auditor? >> Twitter. >> No one knows. Now, the people who invested money, Microsoft probably knows, the big VCs probably know, but even the public auditor for the most important lynchpin name in this entire story. We don't know who the auditor is because it's a private company. It's a not for-p profofit and and that's totally understandable. But if you want to pick on a part of this story, to me, it's a lack of transparency in that one company because we're relying on that company for a lot of >> Open AI, right? So, OpenAI being a $500 billion valuation in the private market, not filing financials publicly. Um, but they do routinely do stock offerings. There's got to be a deck with financials in the in those. It's under NDA. It's not, you know, it's not for public consumption, but somebody is seeing something. >> They are. And that's that is, you know, that's a nice point of clarity. But, you know, we we know SpaceX's auditor. I think it's Ian Y. We know the auditor of some other large priv private companies. Why not at least know who the auditor is for OpenAI? >> Yeah. Interestingly, I remember reading a Bloomberg story about Jane Street, the uh trading firm. >> Sure. >> And uh Jane Street's got publicly traded debt. So, as a result, we do have, you know, it's not a public company, but they've got publicly traded bonds uh or debt so that we're able to see on a somewhat regular basis the financials of Jane Street, which they're not advertising. They're not interested in people seeing it, but it does come out. Um, in the case of Open AI, I think it's an interesting point. If only the most important company in AI were publicly traded and there was a I I guess a heavier degree of scrutiny on things like spending and capex and profitability. But uh again, we're in uncharted territory in so many ways and this is just one more I guess would be the way the way I would think about it. Um guys, it's so great to have you back. Thank you so much for joining us. I want to make sure people know where they can uh follow so they can watch your stuff and uh subscribe and and get your research. So, first things first, we want to tell people to go to data track research.com. >> Yep. >> Okay. And you guys are publishing every day and uh just a unbelievable quantity of information. Uh, I I also want to tell people your YouTube channel is youtube.com/ What is the full URL? It's long. Do you know you know your URL? >> And Jessica Ra. >> Nick. All right. YouTube.com/nickas and Jessica Rae. And of course, there's a link to that in the description if you are watching the video below. Thank you guys so much for joining us. Thanks to Nick and Jessica. We'll talk to you soon. >> Thank you.
A Year-End Rally Could Double The S&P 500's Gain This Year
Summary
Transcript
Ladies and gentlemen, today's show is brought to you by Vanguard. To all the financial adviserss listening, let's talk bonds for a minute. Capturing value in fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top grade products across the board of over 80 bond funds actively managed by a 200 person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So, if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com/audio. [Music] That's vanguard.com/audio. All investing is subject to risk. Vanguard Marketing Corporation distributor Compound Nation. It's the return of Nick and Jessica. I am so excited. Uh, welcome back to What Did We Learn? Uh Nicolas and Jessica Ray are the co-founders of Data Trek Research and the authors of Datrex's morning briefing newsletter which goes out daily to over 1500 institutional and retail clients. Dick and Jessica also have their own YouTube channel which you can find a link to in the description below. Guys, it's so good to see you again. Uh hope all is well. Hope you're getting ready with your Halloween costumes, I guess. What What are we going to be this year? The Vicks. What? What are we thinking? >> Oh golly, the Vix is a great idea. >> How would you do it? How would you do it? You'd have to invent like some sort of VIX creature, I suppose. I don't know. Be a tough one. >> Something asleep for a long time and then it comes up and becomes a monster. >> Yeah, I I suppose. I suppose. All right. Um, we're going to talk about the uh uh the earnings power of the S&P 500, which very appropo to the moment that we're in. This is yet another very I'm this is me my me editorializing. You guys tell me if you agree. I believe that this is yet another very good um quarter worth of earnings with the caveat that we ain't seen nothing yet. Um all the big technology companies are still to come uh very quickly. But if you were just to judge it on what we've seen so far, it's uh I think a sigh of relief and I think it justifies some of at least the rally that we've been enjoying since the summer. What do you guys think about that? >> Yeah, that seems totally fair. Um it's, you know, it's still early early days though. You don't don't want to prejudge too much. >> I I Well, I agree. That's why you're here. Okay. Um you guys say the key to understanding Q3 uh reporting season and valuations can be found in this chart. I'm just going to let you cook. I want to hear what you think. >> Cool. Let's throw up the first chart. This chart shows, it's a fact set chart and it shows by how much the S&P 500 companies beat earnings expectations over the last 5 years. And on the left hand side of the chart, you can see during 21 they were huge beats because nobody thought companies could make as much as they did. So like 14% beat percentages. So if a company was expected to report a buck, they reported a buck 14. Just tremendous. went through kind of a slog in 22. It slowed down a lot and then it picked up again during the current bull market 23 24 and the first half of 25 those two quarters Q1 and Q2 actually had the best earnings beat percentages since 2021. So 8.1 and 79% I think so we were coming off of two quarters of extremely strong earnings beats and right now for the through the last week we're like 5.9%. So, it's pretty good. But the issue is companies, you know, basically didn't really die down this quarter. So, analysts didn't take their numbers down this quarter. So, analysts actually left their numbers unchanged because they gotten beaten so bad in the first two quarters. So, expectations are quite high right now. >> Can we put that chart back up? I want to ask you, so just for the the listener who's not looking at the chart at this moment, we're not saying the percentage of companies that beat. That's a totally different um data series. We're saying the the the amount that earnings were above expectations. So, not the beat rate, but like literally what percentage companies were beating by. And to Nick's point, in Q1, they they beat by 8.1%, which is fantastic. The following quarter, 7.6, but now with a lower beat rate, at least so far. Uh, Nick, I think what you're saying is the analysts aren't getting sandbagged anymore. They're not they're not going to they're not going to play that game where uh you know they they allow their coverage universe to come in and crush their expectations by 20 cents a share. So it's like it's like everyone has now figured out that earnings are going to remain strong which lowers the nominal beat rate uh nominal beat percentage. >> Correct. You know and it's it's it's fine news. It's not anything to be to be worried about. It's just I wanted to point out that the first two quarters were extremely strong and that's goes to a lot of why the market's been strong. Uh perhaps we can just flip over to the next chart because this is Jessica's explanation of how things are going by profit margin by c by um by sector. >> Sure. Yeah. Uh the point here is that it's not just tech improving the S&P 500's overall net profitability. So as a baseline fax faxet expects the S&P 500 to post a 12.8% 8% net margin in Q3 2025, which is a 0.3 point gain from last year's third quarter. And that's also close to the all-time quarterly high of 13.1% in uh 2021. Um, so this chart shows which sectors have contributed to this increase in net profitability. And we also added our notations of each group's year-over-year change in net margins in green to mark a positive comp and red to note a negative comp. And I have just three quick points on this data. The S&P's year-over-year expected net margin improvement for this quarter is due to five out of the index's 11 sectors with financials adding the most at 1.7 points, followed by technology and utilities at 1 and a.5 points each. And then industrials and materials at 0.5 and 0.8 points. And then there's two sectors that are expected to keep net margins relatively stable at0.2. two points for energy and negative0.4 points for consumer staples. And lastly, four sectors are expected to see me meaningful net margin contraction anywhere from down 0.6 to one full point and these are real estate, communication services, consumer discretionary and healthcare. So the upshot here is that while tech has led to higher expected margin improvement for US large caps over this quarter versus a year ago, there's still four other S&P sectors that have also helped. So this shows that this isn't just a tech phenomenon and we think helps support high valuations here since margin expansion should continue with many S&P sectors contributing. >> I want to ask you about two of these sectors, utilities and financials. Um, let's let's do financials first. Uh, chart off for a second, guys. So, a net profit margin expansion uh year-over-year in this quarter um of plus 1.7%. That's really meaningful. These are this is like I don't know trillion dollars worth of market cap or or or $2 trillion worth of market cap. JP Morgan is like 800 billion by itself. So, let's just assume like we're talking about really big companies that are not semiconductors or software. And um I guess my question would be I don't know if you have the data at your fingertips. It would probably be really rare to find a bare market where uh financial companies were expanding margins. That probably never happens. Now, it probably does happen coming out of recessions. >> Yeah. >> Okay. But that's not the situation that we're really in right now. So it kind of feels midcycle when you just think about like financials having that ability to grow profitability. And I know it's a really unique set of circumstances like uh you know longer longer rates holding up, shorter rates finally coming down, a lot of pent up you know things happening in housing etc. But like for me, if you ask me like when would you see financials expanding margins? The last answer I would give you is in a downturn or or I I don't know. It just feels like this should coincide with a continuation of a bull market. Am I extrapolating too much? >> No, we'd agree with you. >> Okay. Utilities has to be the story of the year. Has to be this. This is I've never seen anything like this. The utilities as a group have undergone this insane rerating. They've become growth companies. I believe that they are the top performing sector on the year. They're so small they don't even move the needle for the overall S&P. And then also I think they have higher profit growth than uh technology as a sector. Do I have that right? >> Uh we have to go back and check. That that sounds aggressive. On all the facts side charts, it shows up as less, but perhaps it's a subset of that of that group. >> Okay. All right. I saw something like that where profit growth for the utilities was higher than something. Maybe it's not the tech sector. Um what do you guys think of what do you think? What do you guys think of um that story? I know there it's a small category of stocks >> in the overall markets. I know it's not terribly important to what the S&P does, but it's got to be something that I think is is bolstering the case for a broader rally than, you know, what people would have given us credit for on the surface. >> Well, you've got a couple of things. You've got obviously the tech story and then you've got rates coming down. So, you've got the two things that could really drive both secular demand and then demand for the stocks because the stocks are kind of dividend yield plays. Now, interestingly, consumer staples have not done well this year. So, the yield play itself has not been enough. But you're right, as an old cyclical analyst, I mean, I covered the autos in the 90s. To see a group like utilities get rerated like this really is a, as you alluded to, almost a historic uh event, something that you only see once or twice in your career, and this is happening now. >> Okay. Um, it's really hard to predict whether or not this can continue. Um, I'm just curious when people ask you guys about the utility sector. By now, most growth managers own a bunch of these in their portfolios. Um, probably getting questions about companies that you forgot even were publicly traded. U, these are not bonds anymore. They used to be. Um, so how how do you how do you think about whether or not there are forward-looking opportunities in the space? Is it just about capex and AI electricity demand holding up >> in the short term? Yes. Yes. That's the story that's got to keep it together. You know, it's look, the way we tell clients is it's a better group for for yield than consumer staples. It has a better growth profile. So, it still fits into the yield category, but with a more of a growth bent. >> Okay. Um, all right, let's continue. What's next? >> Next chart. Now, expanding the conversation about earnings, something about valuation. Let's go to the Schiller PE. This is the scary chart that everybody looks at every single day and it shows the Schiller PE which is the based on 10-year average trailing historical earnings. So if you earned if the S&P earned $100 on average over the last 10 years trades for a,000 it's P's shoulder P's 10. Right now we're trading at 39 almost 40 and that's levels we haven't seen since the.com bubble. That's the bump in the middle of the table or the chart. And so we're very very high historic valuations. And this chart bothers a lot of people. So let me flip over to the next chart and kind of try to explain it away a little bit. This shows you S&P earnings by year. Um earnings per share by year. And the current, you know, 39 multiple on the Schiller PE is $167 a share. That's the normalized earnings from which we derive that's 39 Schiller PE. However, the >> you're averaging the earnings per share over the last 10 years to come up with what did you say? 67. >> Correct. >> And now if you look at the last 5 years, 21 to 25, the average S&P EPS is 232 a share. So it's 39 40% better. So I think a problem with the Schiller PE is that we're still using earnings numbers from a long time ago, literally from the mid2010s, where earnings power for the S&P has improved materially since then. Margins are better. Uh revenue growth has been good. And so if you're looking at just the last five years of of of earnings, the Schiller P is more like 28 29, a much more reasonable number. So I don't want to overly excuse high valuations, but I did want to point out that the earnings power of the S&P I think is closer to 230 than 160, 170, 180. And if that's the spirit of the Schiller PE, then its actual number is actually quite a bit lower and it's not as worrisome as that first chart would indicate. It's so funny because 10 years ago when you're saying companies now are materially more profitable and things have changed even 10 years ago and prior like from the from 2012 to 2015 this Schiller cape ratio stuff really got a lot of attention in the markets and it was one of the primary things that people used to keep other people from investing in stocks and they pointed at the year 2000 and they said here we go again and Michael Batnik and and I were talking about this the other day. We we were writing I don't know dozens of blog posts just obliterating the Schiller PE. Not that we don't think there's validity in in looking at long-term averages, but like oh my god, you want to compare Amazon and Apple today versus Bethlehem Steel? Like is it is is this an exercise that's helpful to anyone? It's different stocks. >> Yeah. Forget forget about higher forget about like systematically higher profitability. It's just different companies. If it were like companies and we were saying today's IBM versus IBM in 1985, all right, I'll pay attention somewhat. Um, but I I I kind of find like this whole exercise, it's it's like um it's like thinking about an NBA player in the 1970s and dropping them into the NBA of 2025. >> Like what is the likelihood that that player would would even be able to function in the middle of the court? So, um I don't know. I maybe that's overly dismissive or overly generalizing, but I just think companies are better today at being companies than they were uh 50 years ago. What What do you think about that? >> Well, I'd also say that the top seven companies that are a third of the S&P are really, really good companies with amazing cash flows. And we'll get to this in the third section of the video, but these are amazing companies that are at the top of the stack and they dominate the top of the stack. They're a third of the entire index, those seven names. And so it's not just they're great companies, it's that they're great companies with a lot of weight in the index. >> If you if you guys had to worry about one or the other, I think I know the answer, but which would it be? Worry about valuation on earnings or worry about whether or not earnings growth will continue. >> I sort of think the latter is the thing that's going to decide whether or not stocks can go up and not the former. Like all of a sudden everyone's going to decide, oh, these are too expensive. I like I think they won't do that until earnings growth goes away. >> Yeah. As long as earnings growth supports valuations, it can continue. >> Even ele even elevated. I'd rather buy I guess the way I would phrase it is I'd rather buy an expensive stock market with earnings growth than a cheap stock market without >> and two the lesson from 2000 is you want to buy a market where the Fed's not raising rates because that's what really tipped over the Apple card in April and and May and June and and really cracked the dot bubble. first big crack in the NASDAQ was right after March and it was because of the fact that the Fed was beginning to raise rates again and no one knew how high they would have to go and so that was really the the catalyst. So I just want to layer on the macro side to to the argument but I think you're right. >> Okay. Um what are we saying here? Uh the 24 times consensus estimate for 2026 of 304 a share is 9% upside from here. Why is that important for people to keep in mind? It's important because the S&P valuations over the last call it decade had run from 14 to 22 times. 14 at the trough, 22 at the peak. Um that's been the formula. In order to get a reasonable buy target like 9% up for the S&P, you got to go out to 26. You got to believe in 304 a share which is about 14% growth from this year. That's the fact consensus number. So it's it's fine. It's the Wall Street consensus number. But you got to put a 24 multiple on that. You got to be be comfortable putting a 24 multiple on this market to generate a reasonable S&P upside from here, 9%. If you can't get there, it's probably a tough market to rationalize. We personally think it it merits 24 times, but it's a big number. It's a chunky number. What are the mental gymnastics for us to all be comfortable at 24 times? like what did you guys have to bum I assume we're baking in easier monetary policy continued deregulation um I don't know what like what else do we have to throw into the mix global economic growth >> no I I mean I this is a little bit fil but I really believe it's true you have to absorb the concept of a third of the S&P having a 50 to 60% ROE and that's the big tech names you have to absorb the fact that is materially different from any market we've had four and these companies not only dominate on ROE and return on capital but on the next phase of tech growth which is obviously AI so I think it's the realization that these are truly unique times this time actually may be a little bit different for a while not forever but for a while uh Dr. Ra, do you concur? >> Yes. >> Okay. I assumed you did. All right. Uh let's let's talk seasonality. >> Sure. So, back when we were on in June, uh the peak for the S&P for the year was in February. And we said that was unlikely to be uh this year's high despite the trade shock because it's only happened one other time since 1980. And that was uh that one time was in 1994 when the Fed aggressively hiked uh rates throughout the year. No, no transparency had ahead of that hiking cycle. And our upshot was that the odds are much higher for a Q4 peak barring an exogenous shock when annual returns are usually up by double digits. So um fast forward to now and that turned out to be correct with uh now the S&P's current peak for the year being October 8th. Um, so the table you just had up shows you uh back in June um shows you uh the number of times the S&P has reached its high for we showed you this back in June. Um it shows the number of times the S&P has reached its high for the year and each month back to 1980 along with the average annual returns for each of those uh 12 instances. So, I have just four quick points here. And the first is that the S&P has peaked for the year almost three quarters, 71% of the time in Q4 over the last four and a half decades. So, this year's October 8th high so far is in keeping with those historical norms. And the reason is because US equities usually post annual gains, doing so 82% of the time from 1980 through 2024. And the highs for the year tend to come in Q4 because the S&P has been rallying through the year. And then the second is just that the S&P has always had a positive annual return a total annual return when it has peaked for the year in Q4 and typically by strong double digits up an average of anywhere from 19 to 22%. And when the S&P's high for the year was in Q4, it had positive total uh doubledigit returns, annual returns of 88% of the time, 28 out of 32 years. In the remaining four years, there it was up anywhere from 5 to 8%. So the S&P is currently up 13.3%. So again, that is in keeping with historical norms. And then >> are you saying it's it's a typical year then? >> Yeah, it is. is actually is a pretty typical possible. >> We never think it's typical when we're in it. >> We never like we never nobody would say, "Yeah, this feels normal, but like it's fairly normal what's going on. >> It is." And um but I would just say for the peep being in October that that's a good segue to the third point here. It's that the S&P has actually only peaked though for the year and this is good news for investors. It's really only peaked for the year in October four times since 1980 or less than 10% of the times and those were in uh mostly in the 1980s uh 1983 88 89 and 2007 with an average annual total return of positive 19% ranging from 31 a.5% and 89 to 2007's 5.5% just before um the great uh the great recession. And then the S&P has also only peaked in November uh four times since 1980 as well. Uh also just 9% of the time and those were also mostly in the 1980s uh probably from uh mutual fund uh year ends from um tax laws selling. Um, so I was in 1980, 82, 84, and lastly 1996. And these four years also had an average annual total return of 20% ranging from 6.1% in 84 to 31% uh 31.7% in 1980. But really the the point here is that the S&P has peaked for the year in December 53% of the time back to 1980. the average total return was positive 22%. So given that the first nine months of the year are over, the odds that the S&P peaks in this month or next is 12 1.5% each, while the chances of the index topping out in December are 75%. So, the takeaway here is that with just three months left to finish this year, the S&P has much higher chances of topping out in December, 75% odds, rather than this month or next. And the index would still have to nearly double to meet the average performance of when the S&P does peak in December. Again, an average of 22% a 22% total annual return. So, has plenty of runway left. So overall um we remain bullish on US large cap equities through year end and see any near-term incremental weakness as buying opportunities before that year end melt up. >> So if if the if the if this the typicalness of this year holds up there could be a lot more gas in the tank to get us into the end of the year just to do like an average you know December high. Um, why do you thinkif Why do you think the market makes its high for the year 53% of the time in the month of December? What what's the is there like an anthropological reason for that? Is it is it people that have earned money all year? That's like when they want to get it fully invested before they go away for Christmas. Is it structural? Is it mechanical? What what do you think is behind that? Yeah, it's just that the the the S&P 500 is usually up most of the time and uh and it rallies throughout the year. So, it tends to uh melt up into into uh throughout December. >> Okay, Nick, what do you think about that? >> Yeah, know I think it's fair. I think that's, you know, that's statistically how how it works out. You know, I also think that, you know, come to the end of the year, if it's been an up year, you get a little juice at the end of the year from two effects. The first is just people putting money to work at the very end of the year just for year end showing people that they were invested. And secondly, there's always this big drop involved at the end of the year as options desks take off positions in the final week to not show a lot of a lot of exposure on the balance sheet of banks or brokerage firms >> and you get a bit of melt up too. I think there's some career risk stuff going on and just people that maybe are trailing the index, they get a little bit more aggressive into year end, try to make something happen for themselves as far as like window dressing. Like look, I did own Broadcom. I was in these stocks. I think there's always some of that um which we call it a performance chase or whatever, but like uh I I know from talking to people that it's real. Um, I also think buybacks, which no one's talking about anymore, so we're in this like blackout period with earnings, but when we come out of this period of earnings, you're going to see the buybacks resume again. And I do think that there's, you know, corporations want to get a lot of that done so that when they're reporting Q4 earnings in January and February, um, it's helping their earnings per share. Um, you know, I do think they want to shrink uh shrink the the share count going into year end. And this year, like many years before it, there are a lot of resources at the disposal of these companies. They've made tons of money all year. And I think this is uh I think the buybacks are the thing that like get us going in November um once we get through the big tech earnings. I don't know. Do you think this there's something to that effect at the end of the year? >> That feels right. Yeah. This year for sure. I mean it all depends on how how strong earnings are but yes. >> Okay. Um what's the third thing that we want to do today? Uh >> financial analysis on big tech. >> Yeah. This is a little bit grimy but I thought it's really important because this is ultimately the conversation that the market is having right now and it breaks down into two questions. The first is how much money does big tech actually make and where does it go? Like how much is going into capex and then what's the actual required return on that investment. So the first table and apologies it's going to be bit of an eye chart but the first table shows you the cash flow from operations for the big five companies the big five hyperscalers Microsoft Nvidia Amazon Alphabet and Meta so it shows you cash flow from operations last year and the first half of this year it shows you capex which is the money going into hyperscaling and then buybacks and dividends and it basically breaks down how much of the cash flow from each company goes to those end uses investing in the company capex or handing money back to shareholders by buybacks and dividends. And a couple of big points on this. First, we're not including Apple in this by the way, uh because they're not really an AI hyperscaler, but just these five companies, Microsoft, Nvidia, Amazon, Alphabet, Meta, are generating about $570 billion in cash flow this year. Operating >> Oh, is that all? >> Yeah. Exactly. Exactly. It's like most of the way to a capitalization of JP Morgan. I mean, it's just a mammoth number and people forget that sometimes of that. >> Mick, is that I'm sorry. Is that versus 38 billion a year ago? Can that be true? >> No, it is versus 532 the year ago. >> What's the 38 then? >> The change from last year. >> The change. Okay. All right. >> So, it's 570 up from up 38 billion from the prior year. So, >> perfect. over half a trillion dollars of operating cash flow. This is just straight off the cash flow statement from the the financial statements. Of that 570, about 325 is going into capex. So they have more than enough money to cover the capex budget. And they're still buying back in aggregate about 170 billion in stock and paying out 40 41 billion in dividends. So it's a big misconception that they're plowing all their money into capex. There's still money going back to shareholders. And more importantly, the companies have tremendous operating cash flow. If you were going to add Apple to this, it would add another hundred billion dollars of operating cash flow. >> I was going to say you might have to you might have to do you might have to include Oracle uh next time you do this. >> Yes. Yes. It's a it's a a late a late arrival to the story. One last thing I'd point out is just the way companies spend their money is very different. So Nvidia for example spends almost nothing on capex 5 to 7% and it buys back you know it buys back almost it buys back with its cash flow roughly from half its cash flow. Amazon is the only big tech company left with no dividend and no buyback. So it all goes to capex which is kind of nuts. It's the last pure play you know old school tech name with no buybacks and and no dividends. >> That really is that really look how it sticks out. That really is amazing. I've never seen it I've never seen this stuff laid out this way um with Amazon compared to the others. There is zero attempt to return capital. They just I guess they see the investing opportunity as so much bigger than the opportunity to shrink the share count. >> Yes. I've often thought if I had to cover one of these companies uh as a single stock analyst, the last one I want to cover is Amazon because there is nothing that leaves that shop. the money just stays in that machine and just keeps circulating back and forth. It's It is amazing. It is amazing that that company of that size with, you know, that kind of cash flow, roughly a hundred billion dollars of cash flow, >> is still reinvesting all of it. >> Um the last chart, last table I'll just show you. This is even a little bit griier, but I'll try to summarize it for you. >> This is an attempt to understand how much these companies have to make an incremental cash flow based on the capex that they're putting to work. So if you put in, and this is a very simple corporate finance calculation. So if you put a hundred billion dollars of cash flow to work in a project, you're going to want to see at least a 15% return because that's going to be, you know, the what your return for your your shareholders is. That's being a good steward of capital. And so what I've done is just take the capex budgets, figure out a 15% return on investment, and then work out how much incremental cash flow the companies have to generate to justify the capex that we talked about in the prior in the prior table. And the answers vary, but they're not very high. Amazon, because it reinvests so much, has to generate a 30% return on its capex, but the rest are between 2 and 12 and 15 and 15%. So these companies are so big and generate so much cash flow that they actually could justify their capex investments in Gen AI just with the growth of their organic businesses. So it's a you know people are saying oh when's when's the when's the you know so and so going to hit the fan from all this investment. And the short answer is they're so profitable and generate so much cash flow that we're not going to know for a couple of years at least if this capex and genai actually quote paid off because the underlying cash flows are so strong. I think there are journalists out there who are on the hunt for evidence from internal like documents and memos about concerns within these companies about the levels of spending and the lack of quote unquote ROI on the spending. And it's almost it's almost become like a subgenre of technology journalism is Microsoft is worried that blank or Oracle um executives privately are concerned with I I understand the impulse. It's a really hot story. If and when one of the hyperscalers decides they're pulling back the reins, it has massive ramifications for everyone and everything. So, I understand why the reporters want to be the ones that break that story. I think there's also like a degree of shade and freud um because a lot of people that have missed out on the AI trade, a lot of investors, they want to believe that it's not true and that they couldn't have been mistaken by not owning Nvidia because it's all fake anyway. So, there's that component of the disbelief of these capex numbers. So, I I do think that there are a lot of people rooting for this to end, but to your point, most of this spending coming out of cash flow and you know, like most of this capex spending, it doesn't appear to be the type that's unsustainable. It the numbers are huge, but the cash flows are there to back it. Is that what your table is is proving? >> Yes. And more than anything, this isn't an an analytical point. when you're trying to identify marginal returns on capital for a company, you ultimately only can use the baseline numbers from the entire cash flow statement. So, we don't have the internal ROIs on these new projects. All we can do is judge the aggregate numbers. And by the aggregate numbers, you don't have to generate that much more cash flow to justify these investments because the underlying cash flows are so strong. So, it's going to be hard from as a financial analyst to say, "Aha, Microsoft's ROI went from 15 to 2% in a year because the u the capex for AI didn't pay off." It's it's not going to happen that way. >> Yeah. And because Amazon's a great example, but all of them to some extent, it's a little bit of a black box. The money is fungeable. You don't actually know which dollars are being allocated to what. to your point, you have the aggregate numbers, but you don't know individual projects, which one is very profitable, which one's not profitable at all. Um, nobody really has visibility into that other than people inside of the company in the CFO's office. So, it's really hard to you I guess you could look at the aggregate and make a judgment on the overall company's spending and what did it return, but you don't know which specific AI projects are quote unquote good versus bad. There's some element to that. Right. >> Right. Look, I mean, if you wanted to tell a really negative story about this entire environment, I touched on this last week for clients, and I don't want to make too much of it, but I want to bring it up. We know a lot about where all this money is coming from and where it's going, right? But here's a simple question. Who audits OpenAI? >> Who's the auditor? >> Twitter. >> No one knows. Now, the people who invested money, Microsoft probably knows, the big VCs probably know, but even the public auditor for the most important lynchpin name in this entire story. We don't know who the auditor is because it's a private company. It's a not for-p profofit and and that's totally understandable. But if you want to pick on a part of this story, to me, it's a lack of transparency in that one company because we're relying on that company for a lot of >> Open AI, right? So, OpenAI being a $500 billion valuation in the private market, not filing financials publicly. Um, but they do routinely do stock offerings. There's got to be a deck with financials in the in those. It's under NDA. It's not, you know, it's not for public consumption, but somebody is seeing something. >> They are. And that's that is, you know, that's a nice point of clarity. But, you know, we we know SpaceX's auditor. I think it's Ian Y. We know the auditor of some other large priv private companies. Why not at least know who the auditor is for OpenAI? >> Yeah. Interestingly, I remember reading a Bloomberg story about Jane Street, the uh trading firm. >> Sure. >> And uh Jane Street's got publicly traded debt. So, as a result, we do have, you know, it's not a public company, but they've got publicly traded bonds uh or debt so that we're able to see on a somewhat regular basis the financials of Jane Street, which they're not advertising. They're not interested in people seeing it, but it does come out. Um, in the case of Open AI, I think it's an interesting point. If only the most important company in AI were publicly traded and there was a I I guess a heavier degree of scrutiny on things like spending and capex and profitability. But uh again, we're in uncharted territory in so many ways and this is just one more I guess would be the way the way I would think about it. Um guys, it's so great to have you back. Thank you so much for joining us. I want to make sure people know where they can uh follow so they can watch your stuff and uh subscribe and and get your research. So, first things first, we want to tell people to go to data track research.com. >> Yep. >> Okay. And you guys are publishing every day and uh just a unbelievable quantity of information. Uh, I I also want to tell people your YouTube channel is youtube.com/ What is the full URL? It's long. Do you know you know your URL? >> And Jessica Ra. >> Nick. All right. YouTube.com/nickas and Jessica Rae. And of course, there's a link to that in the description if you are watching the video below. Thank you guys so much for joining us. Thanks to Nick and Jessica. We'll talk to you soon. >> Thank you.