By Lewis KrauskopfThank you for reading this post, don't forget to subscribe!
NEW YORK (Reuters) – The market’s largest stocks are approaching a critical juncture as the pressure intensifies on highly valued technology and growth companies to deliver strong earnings within the context of rising bond yields that threaten to diminish the appeal of equities.
The soaring performance of the so-called “Magnificent Seven” stocks – Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta Platforms – has been the driving force behind the S&P 500’s 12% year-to-date gain, largely due to their significant weighting in the index.
However, this remarkable performance also raises the stakes for the upcoming earnings season. Valuations have surged, with the Magnificent Seven trading at an average forward price-to-earnings ratio of 33.5, compared to the S&P 500’s P/E of 18.3.
Simultaneously, Treasury yields have reached 16-year highs, creating competition for stocks. With risk-free yields of around 5% or higher offered by U.S. government bonds, investors may be less forgiving of companies that fail to deliver strong results.
This appeared to be the case for Tesla, as the electric vehicle maker’s shares declined 7% on Thursday morning after missing Wall Street estimates for third-quarter gross margin, profit, and revenue.
“Everyone is aware that these companies will generate profits,” said Sameer Samana, senior global market strategist at the Wells Fargo Investment Institute (WFII), referring to the Magnificent Seven. “The only question is the pace of earnings growth and whether investors have overpaid for it.”
In June, the Wells Fargo Investment Institute downgraded its rating on the information technology sector – which includes Apple, Microsoft, and Nvidia – from “favorable” to “neutral.”
Results from Microsoft, Alphabet (Google’s parent company), Amazon, and Meta (Facebook’s parent company) are expected next week, while Apple and Nvidia will report next month.
Collectively, the megacap companies are projected to achieve a 32.8% increase in earnings in 2023, while the rest of the S&P 500 is anticipated to experience a 2.3% decline, according to Tajinder Dhillon, senior research analyst at LSEG.
The outlook is further complicated by the persistent rise in interest rates and Treasury yields, driven by a combination of Federal Reserve hawkishness in response to a strong economy and concerns about the U.S. fiscal situation.
Higher yields pose a greater risk to growth and tech companies, as the typically robust projected future cash flows of these companies are valued less when investors can earn more from risk-free government bonds.
The yield on the benchmark 10-year Treasury recently reached 4.94%, its highest level since July 2007.
“People now have alternative investment options that they previously did not have, and their allocation strategies will be different,” said Tim Pagliara, chairman and chief investment officer at CapWealth. “The reallocation of funds going forward suggests lower returns and greater challenges for the Magnificent Seven in maintaining their leadership.”
CapWealth holds Microsoft shares and below-benchmark positions in Apple and Amazon, according to Pagliara.
On Wednesday, Tesla CEO Elon Musk expressed concern about the impact of high interest rates on car buyers.
The market capitalization of the seven companies has also expanded due to their outperformance this year. Earlier this month, their combined market cap exceeded 30% of the total market value of the S&P 500, according to LSEG Datastream.
More than one-third of fund managers identified “long big tech” as the most crowded trade, according to BofA Global Research’s monthly survey released this week.
“This year, the returns in the S&P 500 have been solely driven by the performance of these seven largest stocks, and these stocks have become increasingly overvalued,” noted Torsten Slok, chief economist at Apollo Global Management, in a commentary.
Of course, betting against these market champions has proven to be an unprofitable endeavor. The NYSE FANG+ index, which includes the Magnificent Seven, has surged 140% since the end of 2019 prior to the pandemic, compared to a 33% gain for the S&P 500.
Some investors are making distinctions among the seven stocks. Brandywine Global, for example, holds shares of Alphabet and Meta, which generate significant cash and are more attractively priced compared to their megacap counterparts, according to Patrick Kaser, a portfolio manager at the investment firm.
“All of them are growth stories,” Kaser explained. “However, the source of that growth, its stability, and the level of control over that growth vary significantly among the seven.”
(Reporting by Lewis Krauskopf; Editing by Ira Iosebashvili and Jonathan Oatis)