Today’s market may present a good opportunity to rebalance portfolios, to ensure returns are not ever-more dependent on a handful of stocks – magnificent or not.
The performance of the US equity market has been dominated by just a handful of names over the past year, as investors flocked to the group of stocks known as the 'Magnificent seven'. While these seven companies – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla – sit across several different sectors, all of them have business models that are heavily dependent on technology and the current excitement around artificial intelligence (AI). With many of these names once again delivering stellar earnings results during the latest reporting season, the S&P 500 has reached new all-time highs.
Despite this stellar performance, we advocate careful selection within these big name stocks, with a firm focus on realistic earnings projections. We also argue that the most compelling longer-term returns may be available elsewhere in the index.
Concentration in context
Over the past year, the increased concentration of the US stock market has become a source of interest, if not concern. Close to 90% of the price returns delivered by the S&P 500 over 2023 can be attributed to the performance of just seven stocks: in a year where the S&P 500 returned 24%, the median stock in the index returned a less impressive 8.2% in comparison. The S&P 500 now has a higher level of concentration than was experienced during the 2000s tech bubble.
Is this concentration cause for concern?
One reassuring feature of today’s stock market is that relative to the 2000s, the megacaps are demonstrating tremendous earnings capacity. While these firms make up a large part of the market cap of the S&P 500, they also represent a large share of its delivered earnings – much more than seen in the dot com boom. In other words, today the megacaps are already consistently delivering earnings, rather than merely trading on the hope of future earnings growth.
In part, this increased earnings contribution is thanks to the strength of profit margins. Profit margins for the largest ten stocks stood at close to 20% at the end of 2023, in comparison to around 12% for the broad index. If the megacaps can continue to deliver earnings growth well in excess of the rest of the market, it is possible that they may “grow into” today’s high valuations over time.
The challenge is that with every solid earnings report, expectations for future growth keep moving higher. The largest ten stocks in the S&P 500 are trading on a multiple of 30x forward earnings – earnings which are already expected to expand much faster than the rest of the index. This compares to 18x forward earnings for the remainder of the S&P 500, where earnings expectations are more modest.
Meeting these earnings expectations will in part depend on whether AI lives up to current hype. Although the megacaps operate in different industries, a common theme is that artificial intelligence is expected to be a source of supernormal profits for years to come. Chipmakers are expected to see soaring demand, advertisers will use AI to transform the user experience, and automakers will use AI to make cars drive themselves.
While the speed of rollout and adoption of AI is impressive, its eventual impact is hard to confidently calibrate at this stage. We are mindful that former ‘tech miracles’, such as the internet, often failed to impact productivity and earnings in the way hoped, at either the micro or macro level.
If AI hype proves to be overblown, the megacaps may struggle to keep pace with current earnings estimates. In this case, we may see an outcome more reminiscent of the dot com bubble: the performance of the largest firms might ‘catch down’ to that of other stocks with more prosaic earnings forecasts.
One key earnings risk is the potential for antitrust legislation. Antitrust regulation aims to prevent companies creating a monopoly or colluding together, and its enforcement has increased meaningfully over the past five years. At the time of writing, four of the magnificent seven firms were fighting or appealing antitrust cases. If decisions do not fall in their favour, the sustainability of these stocks’ margins and profits is likely to be impacted going forward.
The other thing for investors to bear in mind is that during tech excitements, all boats tend to rise on the tide – but choosing the eventual winners from fast moving, new technologies is very challenging. For example, at the peak of the dot com boom, Microsoft was trading on 51x forward earnings. Intel – at that point one of the largest companies in the US – was relatively cheaper at a valuation of 40x. Since the dot com peak, Microsoft has returned more than 1,100% to the end of January 2024, well above the broad S&P 500 gain of 400%. In contrast, Intel has posted a total return of just 13%. Having the expertise and depth of research to accurately forecast earnings is crucial. From the top of the dot com boom, Microsoft’s earnings per share have grown more than tenfold, while Intel’s have less than doubled.
What are the prospects for the S&P 493?
Although it is unclear whether AI can live up to expectations, we are not overtly worried about the magnificent seven ‘catching down’ to the broader market in the manner seen in the 2000s. Is it possible that the other stocks – the S&P 493 – catch up?
Conceptually, we would argue that if AI does prove as transformative as some megacap valuations suggest, then a productivity and earnings uplift will be felt across other sectors too. In this situation, we might expect the rest of the index to at least partly ‘catch up’ with the performance of these firms, as investors realise other stocks are also set for an AI-related boost.
History does speak to a ‘catch up’ phenomenon. Following periods of high concentration and wide valuation dispersion, smaller, less expensive stocks tend to outperform. In the five years following an elevated valuation dispersion between the largest ten stocks and the rest of the S&P 500, the equal-weighted S&P 500 tends to outperform the market cap-weighted index. That is, smaller stocks generally do better than the mega caps following elevated concentration.
History also tells us, however, that it can take many years for this convergence to take place. In the shorter term – for example, in the one year following elevated valuation dispersion – there’s no guarantee of smaller firms outperforming. But investors building portfolios for the medium term might be best placed looking for opportunities in the broader market.
Conclusion
The magnificent seven are too big a part of US – and world – stock markets to avoid, and they have demonstrated their ability to generate strong earnings in the past. We would argue, however, that investors should be active in their allocation within the megacaps, tilting towards those companies they think have the best chance of meeting elevated earnings forecasts.
Beyond this, history suggests that we are likely to see returns broaden out over time. Today’s market may therefore present a good opportunity to rebalance portfolios, to ensure returns are not ever-more dependent on a handful of stocks – magnificent or not.