Are the Magnificent Seven stocks losing momentum?

A few things are clear, however, and worth noting. The first is the sheer magnitude of the largest companies’ outperformance of the broader market: The Magnificent Seven generated nearly 60% of the S&P 500 Index’s return year to date through June; in 2023, that figure was 62%. The performance disparity between these few stocks and the rest of the market has been so severe that the Magnificent Seven now represent more than 30% of the S&P 500—and that’s after accounting for a recent drawdown. Within growth stocks, the imbalance is even more exaggerated: Just three stocks in the Russell 1000 Growth Index recently represented one-third of the index.

The second observation is that these kinds of periods of concentrated outperformance in the stock market aren’t unprecedented—think of the Nifty Fifty in the early 1970s and the dot-com bubble in the early 2000s. And when these streaks end—as they invariably do—the reversals can be sudden and severe.

Consider that in 2023 and again through June 2024, the returns for the S&P 500 (which is market capitalization weighted, meaning individual stocks’ weightings are proportional to their overall market value) were roughly double that of an equal-weighted investment in those same 500 companies. Similar patterns of outperformance took place with both the Nifty Fifty and  with tech stocks in 1998–1999. In both cases, when the trend reversed course, an equal-weighted S&P 500 went on to outperform the standard market capitalization-weighted index for six years in a row.

There’s no single reason behind these reversals, but there is a common theme: Companies with lofty valuations tend to come with equally high expectations attached. When growth stalls or fails to meet those high expectations—whether through heightened competition, increased regulation, or management missteps—the consequence has often been a swift repricing.

Recent results for Magnificent Seven companies have raised concerns

Could we be experiencing early indications of a market reversal? The Magnificent Seven companies have reported mixed results from the second quarter of 2024, with weak spots emerging from challenges such as sales and advertising revenue slowdowns and government antitrust actions.

Beyond these near-term headwinds, other challenges remain for the tech titans. Begin with the regulatory risks, which appear to only be mounting: Regardless of which political party is in power next year, the appetite in Washington, D.C., for tighter regulations appears to us to be substantial—and a risk we feel investors should monitor. In addition, many of these companies have begun what’s likely to be a yearslong process of building out their artificial intelligence (AI) capabilities. This process has already come with a huge price tag, but so far the returns on investment are unknown. When AI’s revenue potential is better understood for these early adopters, there’s no guarantee investors will find the investment to have been an attractive use of capital.

Moreover, it’s worth thinking about U.S. growth stocks through a more global lens, including as it relates to the U.S. dollar. During past periods of a strengthening dollar, growth stocks in the United States have fared relatively well as asset prices rose and multiples expanded. Since the start of 2023, the dollar has essentially moved sideways, after peaking in late 2022. With the U.S. Federal Reserve likely to begin cutting interest rates in mid-September 2024 as of this writing, it’s a fair question to ask whether the dollar could be poised to weaken further, which historically has favored value over growth stocks, as multiples in many parts of the equity market compress.

Value stocks appear poised for an earnings rebound

All of these factors considered, the Magnificent Seven’s earnings growth was recently expected to decelerate in this year’s fourth quarter to a rate only slightly higher than that of the Russell 1000 Growth Index, according to analysts’ consensus estimates. Meanwhile, large-cap value stocks were expected to continue strengthening their earnings figures, rebounding from around 3% growth in this year’s second quarter to more than 15% by year end.

The question facing investors is how much they’re willing to pay for these levels of earnings growth.  The Russell 1000 Value Index recently reflected a trailing price-to-earnings (P/E/) ratio of about 19x; the cheapest of the Magnificent Seven, meanwhile, had a P/E ratio of about 22x, and two of the seven were over 50x.¹ If the momentum that recently fueled the rise of the Magnificent Seven stalls, it could suggest a meaningful resurgence in value-oriented and smaller-capitalization stocks, in our view.

One month of data is too little from which to draw any meaningful conclusions, but it’s noteworthy that real estate, the worst-performing S&P 500 sector over the first six months of 2024, led the broader market in July, while information technology and communication services, the two best-performing year-to-date sectors through June, were the only two sectors that posted losses in July. Similarly, value outperformed growth across all market capitalizations in July, while small- and mid-cap stocks outperformed large caps.

Diversification may be more important—and challenging—than usual

If investors do eventually lose their appetite for today’s high-flying tech stocks, only hindsight may reveal precisely when the sentiment shift transpired. But we can say with confidence that, over the long term, valuation matters in the equity market, and that chasing yesterday’s top performers rarely ends well. Consider the recent, short-lived turmoil that hit the markets at the beginning of August and erased approximately $800 billion in market value of the Magnificent Seven in just one day. Investors following a passive or index-oriented approach could discover too late just how exposed they are to the fortunes of a handful of tech-related mega caps. If history is any guide, when market leadership changes, that change can often be both abrupt (as 2022 was for tech) and protracted (it took roughly 15 years for tech stocks to recapture their highs from 2000). We believe achieving a meaningful level of diversification in today’s market requires a hands-on, active approach—and after the spike in volatility in early August, we’d suggest investors prepare for the possibility of more turbulence on the horizon before it arrives.

1 Yahoo Finance, as of 9/10/24.