Giants with feet of clay?
86%: this is the share of S&P 500 performance (excluding dividends) realised this year by the “magnificent seven” – Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla[1] – which together represent just 27% of the index. During the course of a year when equally weighted indices are close to breakeven, and small/mid-cap and value stocks have often been in the red, they have – more or less – singlehandedly driven the performance of the US equities market. Like Akira Kurosawa’s “Seven Samurai” whom their nickname indirectly references[2], these technology giants have defended Wall Street against the attacks threatening to bring it down – severe monetary tightening, the regional banking crisis, the brutal slowdown in real estate and manufacturing activity, and geopolitical tensions, etc. Can these seven stocks continue to stand as the last bastion that holds the rude health of the US stock market intact? It looks like a tricky challenge.
To start with, the beginning of 2023 offered an ideal entry point for these technology stocks after a disastrous 2022 in which they lost between 26% (Apple) and 65% (Tesla). An annus horribilis that strongly depressed valuations, making them particularly attractive. In theory, this is no longer the case today. The 12-month forward price/earnings or P/E ratio for the magnificent seven is now 1.7 times higher than the median of the S&P 500 and well above the past trend. However, this does not hold true if we consider the price/earnings-to-growth or PEG ratio. This adjusts the P/E ratio for the rate of expected earnings growth over several years, and on this basis the magnificent seven are no more highly valued than the rest of the US market, unlike the situation at the end of 2021, for example.
This is due to a remarkable phenomenon: earnings growth expectations for these stocks have been consistently upgraded in recent months. On a short-term horizon, the 12-month forward earnings expectations for the S&P 500 have been revised by just a few percentage points during the course of the year, whilst those for the magnificent seven have leapt 70%! The corollary of this optimism surrounding the technology giants is that everything now rests on their ability to deliver the expected results. From here, we need to ask another question, namely, can these companies weather a sharp economic slowdown or even recession without the slightest damage?
Whilst their dominant positions, enormous cash reserves and capacity for innovation all offer protection, we should bear in mind that their underlying businesses have a significant element of cyclicality. Advertising – an important business for Meta and Alphabet – and corporate services, specifically via the cloud – for Alphabet, Amazon and Microsoft – are highly dependent on corporate investment, which tends to slow during recession. The same is true for discretionary household consumption, on which Apple, Tesla and Amazon are to some extent dependent. Cyclicality is even more obvious in the semiconductor market to which Nvidia is directly linked. It thus appears unlikely that the magnificent seven would emerge unscathed from a period of recession. Of course, this would not cast doubt on their strength, particularly bearing in mind that, for several years now, these stocks have often outperformed expectations, even when these were high. Nonetheless, the very high expectations for these companies make them particularly vulnerable to any negative surprises.
Final version of 17 November 2023 – Enguerrand Artaz, Fund Manager