The S&P500 is virtually unchanged this year, but beneath the surface the US equity market is moving more than it has in years. More than one fifth of all stocks in the index have already risen or fallen by more than 20 percent this year. The gainers are clearly in the majority: about two out of three. Yet you do not see that reflected in the index itself. How is that possible?
The largest stocks are declining, while the rest are rising. It is the biggest rotation since the global financial crisis.
Tech giants as a source of cash
For three years, the Magnificent 7 (Apple, Microsoft, Amazon, Alphabet, Meta, Nvidia and Tesla) defined the market narrative. They pushed the S&P500 ever higher, while the average stock lagged behind. Now the roles have reversed. The equal-weighted S&P500, in which every stock counts equally, is posting new records.
The traditional market capitalization-weighted version, which consists for nearly 40 percent of tech giants, is stagnating. More than 60 percent of stocks are outperforming the index as a whole. Investors are selling the large, well-known tech names and using the proceeds to buy smaller stocks, cyclical companies, commodities and international equities.
Lower valuations, higher earnings
Remarkably, the valuation of the Magnificent 7 has declined significantly. After years of price gains that outpaced earnings growth, investors are now paying substantially less for every dollar of profit. The price-to-earnings ratio of this group has fallen clearly. At the same time, earnings expectations for the Magnificent 7 continue to be revised upward. These seven companies are expected to grow their profits faster than the rest of the market. After all, they have the scale advantages, customer base and technological edge to benefit from AI.
That makes the current situation unusual. The market is treating these companies as if something is fundamentally wrong, while the results show the opposite. The price declines are not driven by weak numbers, but by doubts about whether the massive AI investments, totaling 660 billion dollar this year—no less than 60 percent more than last year—will pay off quickly enough. It is a question of patience, not of quality.
No typical leadership change
In a bull market, leadership rarely changes. The early winners typically remain the winners until the end. A true leadership shift usually accompanies a break in trend: the end of a cycle, a recession, or the bursting of a bubble. Think of 2000, when the dot-com bubble burst and the equal-weighted index rose nearly 18 percent, while the market capitalization-weighted version declined.
That raises the question: is this the beginning of such a break in trend, or merely a temporary pause? There are good reasons to believe it is the latter. The US economy is growing solidly. Earnings growth is broad-based: margins are improving in seven of the eleven sectors. Revenue is rising by 9 percent. This is not a market in decline. It is a market that is broadening.
The world outside the US
The shift is not limited to sectors. Investors are reallocating capital globally from the US to Europe and emerging markets. The allocation to emerging markets has risen to its highest level since early 2021. The overweight position in the euro has reached a record not seen in twenty years. Capital is flowing into energy, basic materials and consumer staples. Nearly half of fund managers expect value stocks to outperform growth stocks in the coming year.
The manufacturing sector, which contracted for two years, is now recovering, from the US to Germany and Japan. AI investments are filtering through to the broader economy and driving demand for commodities. Declining energy costs and global monetary easing are helping as well. But growth is being driven almost entirely by higher productivity, not by more jobs. Every million dollar of additional GDP is generating fewer and fewer jobs. AI is producing jobless growth.
What does this mean for investors?
The temptation is strong to completely abandon the Magnificent 7 and go all in on the laggards of recent years. But that is too simplistic. The lower valuation combined with higher expected earnings growth once again makes this group attractive for investors with a longer horizon. The difference from 2000 is that today’s tech giants are generating enormous profits and continuing to grow them.
The smartest approach is to achieve better balance in portfolios. Diversify more broadly than in recent years. Consider a mix of market capitalization-weighted and equal-weighted indexes. But do not throw the tech giants overboard. After the recent price declines and at current valuations, they are likely the best bargains in the market. The market is not changing direction; it is changing composition. And that broadening makes this bull market healthier than it has been in years. Under the leadership of the Magnificent 7.
Han Dieperink is chief investment officer at Auréus Vermogensbeheer. Earlier in his career, he served as chief investment officer of Rabobank and Schretlen & Co.