The S&P 500's Record Profits Are Hiding a Problem Investors Haven't Seen Before
Companies are recognizing revenue now. But the costs are only likely to start showing up in the years ahead.
Record corporate earnings have fueled stock prices for the S&P 500, with Q3 estimates predicting a 29% year-over-year earnings growth. This trend is expected to continue, particularly among mega-cap companies, over the next couple of years. However, a hidden risk may threaten these impressive numbers. The issue lies in how companies account for investments and revenue related to them, potentially creating a problem that will surface in the distant future.
For instance, when a tech firm invests $1 billion into AI development, the companies providing the necessary hardware and infrastructure recognize revenue immediately. Still, the investing company often spreads the expense over several years through depreciation, which only begins once the project is operational. Consequently, the company's revenue and earnings appear elevated now, but the expense has yet to materialize.
This discrepancy raises concerns about sustainability when the earnings growth eventually slows, coinciding with rising expenses. While massive spending on AI development initially appeared positive, investors are now scrutinizing the return on investment (ROI) and free cash flow. Companies like Alphabet, Intel, Amazon, and Meta Platforms have all experienced significant stock price drops due to ballooning infrastructure spending and negative free cash flow.
With investors shifting focus to free cash flow, there are growing concerns about the sustainability of this spending spree. Long-term asset allocations remain sound, but heightened volatility may ensue. Investors with a lower risk tolerance might consider the Invesco S&P 500 Equal Weight ETF to mitigate exposure.
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