Why It Could Be Time To Sell The Magnificent Seven

Why It Could Be Time To Sell The Magnificent Seven
Sam Benstead via interactive investor

about 2 months ago5 mins

Mentioned in story

Just seven companies accounted for around two-thirds of the S&P 500’s 24% gain in 2023. The so-called Magnificent Seven – Amazon, Apple, Tesla, Alphabet, Microsoft, Nvidia, and Meta – individually soared between 50% (Apple) and 240% (Nvidia), placing them among the market’s most profitable bets. But those gains came with a catch: more expensive valuations. These seven stocks now trade at an average forward price-to-earnings ratio of 44 times – more than double the S&P 500’s average – making them some of the priciest stocks out there.

So it’s worth taking a look at what might happen next.

Can the AI frenzy continue?

The driving force behind the recent returns from the Magnificent Seven has been the boom in AI, with the rise of large language models (LLMs) like OpenAI’s ChatGPT driving much of the excitement. The buzzy ChatGPT, whose technology is being embedded across Microsoft’s products, can be used to assist with writing, computer coding, image generation, and more. (No wonder, then, that Microsoft is a big investor in OpenAI.) At this point, AI models are being developed and deployed by all the Magnificent Seven firms, apart from Nvidia, which sells the computer chips that the models run on.

And that’s setting the stage for changes in how the world works. The question is whether this transformation is overhyped.

Ben Rogoff, manager of Polar Capital Technology Ord investment trust, says he’s more excited than ever about the potential for AI. A year after the public launch of ChatGPT, he says, the world stands at a “unique moment in the evolution of the technology landscape, with generative AI as important – if not more important – than the internet and the smartphone.”

Furthermore, he says that the “diffusion rate” – basically, how long it takes for new technology to become widely adopted – is likely to be far quicker for AI than it was for those other tools, with billions of global users granted early, almost instant, access.

If Rogoff is right, and we’re at the dawn of a new era of technology, then the AI investment theme is likely to continue going strong – with the Magnificent Seven likely to be right at the center of it all.

But haven’t their shares become a bit too expensive?

Sure, AI developments from this elite band of companies could lead to greater profits and revenue generation, but there’s still a danger that investors today are overpaying for their shares.

In fact, Rogoff says that given the strong run in 2023, it wouldn’t be surprising to see a near-term pullback in these seven companies’ stock prices – especially since investor sentiment overall has become more positive. He says he’s personally keeping an eye out for signs that traders are taking profits on their shares in AI-related companies and the Magnificent Seven.

Indeed, that’s how 2024 kicked off. The tech-heavy Nasdaq 100 index, for example, dropped 2% in the first trading week of the year, before moving higher again. That said, the index had reached a new all-time high just the month before, having lost around one-third of its value in 2022.

So those gains in the Magnificent Seven, Rogoff says, though “exceptional”, in part, also reflect a pretty depressed starting point, given their poor performance in 2022, when the group fell by about 40%.

Looking more long-term, he says, he doesn’t see those tech superstars repeating their recent impressive performance but instead sees a “broadening out” of winners from the AI megatrend.

Bank of America analysts tend to agree: they expect more of the index’s returns to come from companies outside the Magnificent Seven and are warning about the risk of investors becoming overexcited about Big Tech. And that’s beginning to play out already: since mid-November, the equal-weighted S&P 500 has easily outperformed the market cap-weighted index.

On the other hand, they said, there’s the risk that the continued boom in passive investing could push more money into larger companies, basically “feeding growth” for giant firms and the Magnificent Seven.

Another negative voice on the Magnificent Seven comes via UK fund managers at Schroders, where fund managers Alex Tedder and Tom Wilson say it’s “time to do the opposite of what you did in the last decade”.

Sure, over the past 10 years, all investors had to do was buy equities and invest for growth. But now they say a “reset” is under way, and with greater returns on cash, a new investor toolkit should include more diversification across regions, such as fewer US shares and more from the rest of the world, and a renewed attention to valuation, quality, and risk.

The S&P 500 may well continue to trade at a premium to other markets – nonetheless, it’s worth bearing in mind that the valuation gap between the US and the rest of the world is now at extreme levels. Historically, that kind of polarization can persist for a good long while, the fund managers said, but “inevitably, at some point, the gap closes”.

So how can you invest to back or avoid the Magnificent Seven?

Investors worried about a fall for the Magnificent Seven could look instead at funds that own small and mid-sized companies. Super 60 funds that invest in this part of the market include Artemis US Smaller Companies, abrdn Global Smaller Companies, and Henderson Smaller Companies.

Value-focused funds are also highly likely to avoid the Magnificent Seven, such as the ACE 40-rated Schroder Global Sustainable Equity or the Super 60-rated Artemis SmartGARP Global Equity.

Equal-weight funds, which attempt to have the same amount invested in each company in a portfolio, are another potential way to go: for example, the iShares S&P 500 Equal Weight ETF or the Invesco S&P 500 Equal Weight ETF. A recent article from ii explained the main benefits of an equal-weight index.

Investors who think the Magnificent Seven will keep up its stellar performance can gain access via a Nasdaq 100 tracker fund, such as Invesco EQQQ NASDAQ-100 ETF or the iShares NASDAQ 100 ETF. All seven shares are represented in the top ten holdings of these popular exchange-traded funds.

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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