‘Magnificent 7’ stocks: bubble or a new beginning?

Important information - the value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Past performance is not a reliable indicator of future returns

But that was last year. The quandary for investors is what to do now - deliberately reduce exposure or keep faith that the pre-eminence of the Magnificent 7 will continue?

Why did the Magnificent 7 perform so well last year?

One feature the Magnificent 7 share is their ability, in the market’s view, to grow their earnings strongly for years to come. That’s a great quality in a company at any time, but it’s particularly great when inflation and interest rates are low because it means all those future earnings won’t be eroded away by rising prices. When expectations for inflation and interest rates rise, as happened rapidly in 2022, these companies take a hit.

Last year the stock market began to look forward to inflation and rates peaking, and eventually, falling, and the Magnificent 7 surged. That may have been in hope rather than expectation at first, but gains gathered pace once it became clear that inflation was falling in earnest.

Meanwhile, as other sectors were buffeted by fears of recession, the Magnificent 7 looked even more attractive as investors fled to companies they saw as defensive. The products and services these giant, capital-light companies provide are now critical to consumers and businesses and so they appear well-placed to handle any economic storms that may come.

How they might they perform in 2024

Their performance from here continues to depend on the path for interest rates, which in turn depends on the performance of the global economy. We think the most likely outcome is a mild recession. If that happens, investors are likely to see high-quality growth companies as solid defensive options, and the Magnificent 7 could benefit.

But there’s a material chance that we get no recession at all. In that scenario the rest of the stock market make up ground on the Magnificent 7.

It’s also important to consider valuations. Below we list current price-to-earnings ratios for the Magnificent 7, based on the next 12-months of forecasted earnings.

Alongside that are ‘PEG’ ratios - or ‘Price/earnings-to-growth’. This measure shows the relationship between the price-to-earnings valuation and expected earnings growth over the next five years. A reading of 1 suggests the price-to-earnings valuation is fair based on expected earnings growth. Above one means the valuation is not supported by expected future earnings.

As with any valuation measures, they can only tell you part of the story and may be dependent on the accuracy of forecasts.

Source: Yahoo finance/Nasdaq, January 2024

The readings suggest that some of the Magnificent 7 - Apple, Microsoft and Tesla, in particular - need to produce very strong earnings growth to justify their current valuations. They may not be headed for big falls, but the startling rises of 2023 may be hard to repeat.

How can you tell if you’re now overexposed?

You don’t need to be holding shares in these companies directly, or even via a dedicated US fund, to have a significant exposure to them. Their size means even global equity funds are likely to hold big positions in them. That’s fine if it’s a conscious decision but you want to avoid becoming too exposed by accident. If you invest via funds, garner what information you can from factsheets, including top 10 holdings and regional breakdowns, to get an idea of your exposure.

You may want to reduce your weighting but do consider that, by doing so, you will be reducing your exposure to the biggest recent driver of investment gains.

A quick way to do it is to use an equal-weighted index fund for your investments in the US. These invest equal amounts in all the companies in the S&P 500 rather than allocating by size of company. An example that is available on the Fidelity platform is  the Invesco S&P 500 Equal Weight Index ETF.

As our valuation data show, there can be big differences between constituents of the Magnificent 7 and it can be hard for ordinary investors to choose between them. This is where an actively managed fund can help. Several of the funds on our Select 50 list of favourite funds invest in the Magnificent 7 according to the analysis of their management teams - overweighting some but underweighting others. 

The BNY Mellon Long Term Global Equity, Fidelity Global Special Situations and Rathbone Global Opportunities do this within a portfolio of global stocks. 

The Brown Advisory US Sustainable Growth and Dodge & Cox US Stock funds do so concentrating only on the US market.

Five-year performance table

Past performance is not a reliable indicator of future returns

Source: Refinitiv, as at 31.12.23 Basis: Total returns in GBP. Excludes initial charge.

Source:

^1,2 Schroder Equity Lens, December 2023

Check which companies you hold via funds using Portfolio X-ray

If you have investments on the Fidelity platform it may also be useful to check for significant overlaps in your portfolio using the ‘Account holdings report’ within your account. You can select a benchmark to compare your portfolio to and then click ‘Export’ to view a ‘Portfolio X-ray’ report based on Morningstar data.

The report will highlight where holdings across your portfolio - even those held via funds - overlap. This fictional portfolio, for example, shows a 1.16% exposure to Apple shares through three of the funds held.