Problems with the Magnificent Seven Stocks

Vincent Deluard, StoneX global macro strategist, asks: are we at an inflexion point, when higher bond yields and a steeper yield curve could hit the rating of expensive growth stocks? The Magnificent Seven (Mag7) stocks have become synonymous with this bull market: Amazon, Alphabet, Apple, Nvidia, Meta, Microsoft and Tesla. These stocks make up a quarter of the S&P 500 market value.

The Mag7 portfolio

Last year was challenging. Investors were confronted the worst inflation shock in 40 years, a complete about-turn in monetary policy, and underperformance of the traditional 60/40 equity/bond portfolio. In comparison, 2023 was boring. What mattered for investors was how much exposure they had to the Mag7 stocks. Yet except for Nvidia and Tesla, the Mag7 have struggled to see revenues keep up with nominal economic growth. Their valuation premium is now larger than it was during the COVID lockdowns, when they first rallied. There are signs that Mag7 grip on market leadership is slipping, falling on average 11% from summertime peaks.

Growth stock risks

Deluard argues that we now potentially face years of underperformance by these megacap growth stocks. He offers four arguments for this view:

• Megacaps have a higher premium higher today than it was during COVID, when these stocks benefitted most from the extraordinary boost to online spending caused by lockdowns and stimulus checks.
• Growth stocks derive most of their capitalization size from their expected long-term earnings, and these long duration stocks should suffer the most if bond yields rise.
• Five of the big tech companies’ revenues’ are struggling to keep pace with economic growth (Nvidia and, to a lesser extent, Tesla still post extraordinary growth).
• Given their weight in the major indices, who will be left to buy the Mag7 in 2024?

Performance of Growth and Value Indices

 

Source: Bloomberg, toneX.

Valuations historically high

Deluard argues that a highly-valued non-dividend-paying growth stock should have the duration of a very long-term bond. Conversely, value stocks’ generous dividends and high book value are the equivalent of a short-term, high-coupon bond. Historically, growth stocks have indeed been more correlated with long-term Treasuries than value stocks. Value stocks should outperform growth stocks when long term bond yields rise.  This year we have seen the benchmark 10-year US bond yield rise to 4.5%, close to a two-decade high, up from 3.25% over the summer, with no sign that they have peaked.

Growth / Value Relative Strength versus 10-Year Yield

 

Source: Bloomberg, StoneX.

Correlation of Growth/ Value Relative Strength versus 10-Year Yield

 

Source: Bloomberg, StoneX.

Historically expensive

However, Deluard adds, the Mag7 stocks are about twice as expensive as the rest of the index on a price-to-sales basis. At this point, the S&P 500 index is made of two indices of almost equal size: the highly-priced mag seven, and the remaining 493 companies. The premium is especially large if we compare the P/E of the Russell Top 50 Megacap Index with that of the S&P 500 equal-weighted index.

Tech megacaps command a 78% premium, which is even larger than the peak logged during the COVID lockdowns. The premium could be justified in terms of growth back then because US consumption was boosted by stimulus checks, and skewed towards online purchases and instead of services, travel, and transportation.

Why should big tech’s premium be higher now that their sales and earnings growth has normalized and that consumers are engaging in “revenge spending” on real-world experiences, such as $4,000 tickets to attend Taylor Swift’s Era’s Tour?

Valuation of Tech Megacaps versus the S&P 500 Equal-Weighted Index

 

Source: Bloomberg, StoneX.

Revenues and profits slowing

Revenues and profits are slowing for at least some of the Mag7. Nvidia and, to a lesser extent, Tesla are still growing at an extraordinary pace, but the big five platforms (Apple, Amazon, Microsoft, and Alphabet) have become mature companies whose massive revenues barely keep up with nominal GDP growth. Their collective net income fell to $263 billion in the past four quarters, down 9% from $289 billion the year before.

Added to revenue concerns are some worrying stock specific headlines. “Justice Department Sues Google (Alphabet) for Monopolizing Digital Advertising Technologies”. “China’s Apple iPhone Ban Appears to Be Retaliation.” “Tesla’s Cybertruck has a serious problem that only a complete redesign can fix.” “Meta faces a future of more legal woes and falling revenues.”

Magnificent Seven Revenue and Profit Growth

Source: Bloomberg, StoneX.

Rate-sensitive valuations

The money market fund-like balance sheets of the magnificent seven may help to explain the paradox which has so greatly hurt my personal account and sense of logic this year: they have large cash balances and debt issued during the low-rate era, providing the Mag7 with $709 million in net interest income in 2022, against a net expense of $668 million at the end of 2021.

What should an investor do?

Deluard cautions investors to look abroad: there are attractively priced good growth stocks outside of the US, and he argues that they should fare better in what he believes will be a coming correction. The foreign growth category is a diverse bag of European pharmaceuticals, French luxury groups, under owned Chinese tech platforms, and emerging markets banks. The natural diversification of international growth stocks should be an asset compared to US growth funds, which invest overwhelmingly in the same five large platforms with considerable overlap in the fields of cloud computing, consumer electronics, online entertainment, and social media.

Further, he argues that US-focused investors may want to focus on stocks which belong to the second decile in terms of growth of valuation (the next ten percent of stocks outside of the top ten per cent.)  True value stocks have decent fundamentals, so they usually have high-but-not-extreme dividend yields. 

The 2023 rally was all about extremes so far: the biggest stocks did best. So did the most speculative ones, and those stocks with the most eye-popping growth forecasts. Investors should find comfort in steady, boring, reasonably-priced large companies in the coming correction.

Analysis by Vincent Deluard, CFA, Director, Global Macro Strategy. [email protected]

Edited by Paul Walton, Financial Writer: [email protected]