Fracturing ‘Magnificent Seven’ trade puts spotlight on megacap valuations

Diverging fortunes for the massive technology and growth names that have propelled the US stock market higher are throwing a spotlight on their pricey valuations.

The so-called “Magnificent Seven” are collectively trading at an average of 33 times their expected earnings for the next 12 months, up from 26 at the end of 2022, according to LSEG Datastream. That compares with a price-to-earnings ratio of about 21 for the benchmark S&P 500 index, which has risen over 7% this year.

Investors last year were happy to pay up for the megacaps, given the companies’ solid balance sheets and dominant positions atop their industries. They have been more discriminating this year, punishing the shares of Tesla and Apple when their outlooks turned murky while fueling dizzying gains in Nvidia.

“When you get to those kinds of valuations you have no room for failure, no room for disappointment,” said Mike Mullaney, director of global markets research at Boston Partners.

Concerns about electric vehicle demand have sparked a near 35% drop in the shares of the former market darling Tesla this year, making it the S&P 500’s worst performer. The stock traded at about 65 times forward earnings at the start of the year, and is down to about 50.

Another Magnificent Seven member, Apple, has ceded its perch as the biggest US company by market value to Microsoft after its shares declined 10% year-to-date, amid pressure in its China business. The stock’s P/E has fallen from 29 to 25.

Meanwhile, chipmaker Nvidia, which trades at about 35 times earnings, has soared about 80% as it established a dominant position in artificial intelligence applications. AI optimism has also helped drive a nearly 40% gain in Meta Platforms. The Facebook parent trades at 24 times earnings.

By contrast, the Magnificent Seven last year advanced about 50% for Apple to over 230% for Nvidia. Because of the stocks’ heavy weighting in the S&P 500, the group’s performance accounted for over 60% of the index’s appreciation last year. The S&P 500 rose 24% in 2023.

Markets are awaiting the coming week’s Federal Reserve policy meeting, which concludes on Wednesday. A strong economy and sticky inflation have lowered investor expectations for how much the central bank will cut rates this year, leading to a rise in Treasury yields that could pressure stocks if it continues.

Investors gauging whether Nvidia can parlay its massive lead in AI computing into long-term dominance will be watching the company’s developer conference, set to kick off on Monday.

Though AI optimism has helped lift a swath of the Magnificent Seven, many investors are grappling with how to weigh the technology’s potential in their valuation models.

“We are in a unique cycle here with AI, so we are struggling to make sure we optimize the opportunity of this massive transitional shift in technology,” said Ken Laudan, portfolio manager for the Buffalo Large Cap Fund, which holds the seven stocks but is underweight them on a combined basis.

While robust earnings have supported the Magnificent Seven’s valuations, the group’s growth trajectory is due to moderate later this year or early next, said Jeffrey Buchbinder, chief equity strategist for LPL Financial.

“At that point, markets may not want to pay double the P/E for this group,” said Buchbinder, pointing the Magnificent Seven’s trailing P/E of 41 versus 23 for the S&P 500.

Many investors remain sanguine regarding the Magnificent Seven’s valuations. Five of the seven are trading below their five-year median P/E ratios, while the group is trading more cheaply versus the market than a few years ago, JPMorgan strategists said this week.

Nvidia’s P/E has actually fallen from nearly 60 a year ago as analysts increase their profit forecasts for the chipmaker.

“These are companies that are cranking out enormous amounts of cash, very strong balance sheets, visible sources of revenue growth,” said Katie Nixon, chief investment officer for Northern Trust Wealth Management.

But Apple and Tesla’s shares have recently fallen below their 200-day moving averages. Though the rest of the group are above that mark, more of the Magnificent Seven dropping below their trend lines could be a “warning sign” for the market, Citigroup analysts said.

If the Magnificent Seven “start to go down... absolutely you could reverse a lot of the recent almost euphoric sentiment,” said Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute.

US stocks fell on Friday, led by technology-related megacaps that have propelled this year’s rally, while investors weighed the interest rate outlook ahead of next week’s Federal Reserve meeting.

Traders have reined in bets of a June rate cut by the Fed after this week’s hotter-than-expected inflation data.