Digging into the big tech rally

Authored by: Jonathan Linden, Elyse Ausenbaugh, and Matthew Landon

The milestones keep rolling in for the equity market. 

The S&P 500 closed above 5,000 for this first time ever after yet another week of gains. That marks the 14th weekly increase in the last 15 weeks — something investors have not seen in over 50 years.

With just a small handful of megacap tech companies leading the charge higher, market concentration is now at its highest level since the early 1970s.

The good news? Those heavy hitters have once again proven their value in fourth-quarter earnings against lofty expectations, and we are seeing strength broaden out beyond just the Magnificent 7 stocks. Today’s note takes a deeper dive into what we have learned so far from the megacap reports and where we see opportunity.

Are the “Magnificent 7” really that magnificent?

Just seven stocks — Apple, Amazon, Alphabet, Meta, Microsoft, Nvidia and Tesla — account for almost 30% of the S&P 500 market cap. Those seven companies have contributed more than half of the S&P 500’s 31% rally since the start of 2023. The magnitude of gains in some of the single stocks over that time period has been astounding: Nvidia share prices have more than quadrupled, Amazon’s have doubled, and Microsoft’s and Alphabet’s are up more than 70% and 60%, respectively.

We think the gains have been justified. The latest earnings reports from the cohort, save for Nvidia (theirs will come in next week), show three key dynamics that have pushed the names to new highs:

1. Earnings growth is picking up steam and looks likely to stay strong. 
2. Valuations remain reasonable, despite the recent rally. 
3. The potential of artificial intelligence is accelerating, and the Magnificent 7 are both enablers and beneficiaries of it. 

That said, not all of the companies included under the Magnificent 7 moniker have shined equally. Tesla, for example, is becoming something of the runt of the group, having fallen out of the top ten list of the world’s largest companies. Voices on the Street have even started to question if Tesla belongs in the Magnificent 7. As such, our piece today will focus on the other six companies in the group.

Earnings growth is picking up steam

The earnings story for the Magnificent 7 starts with cost control measures put into place after 2020’s pandemic-era tech binge turned into a hangover in 2022 and part of 2023. Amid a slowdown in demand across business functions, the “hyperscalers” (Microsoft, Amazon and Google) tightened their belts on costs and reduced headcount to protect profit margins. 

Then ChatGPT burst onto the scene. Not only did the platform bring artificial intelligence (AI) into the limelight, it also increased real demand for AI implementation and related services. We expected that the AI craze would ultimately create a reacceleration in cloud growth — something that came to fruition this earnings season. Microsoft’s Azure, Amazon’s Web Services, and Google’s Cloud Products all beat growth expectations in the fourth quarter, and management teams struck an upbeat tone on forward guidance.

The combination of leaner cost structures and reaccelerating demand has offered a boost to earnings estimates for the year ahead.

Valuations still look reasonable, even in light of the recent rally

After rallying more than 100% in aggregate in 2023, the Magnificent 7 stocks have shown no sign of slowing this year. Valuations have expanded modestly, but a larger proportion of the increase can be attributed to rising expectations for earnings in the year ahead.

At face value, there is no denying that the megacap stocks trade at a premium to the rest of the S&P 500. But when comparing the aggregate forward price-to-earnings ratio to history, it is roughly in line with the 10-year trailing average. Given our confidence in the earnings trajectories, we prefer to look at valuations on an earnings growth-adjusted basis. This measure, called the price-to-earnings-to-growth ratio, shows that the Magnificent 7 valuations still look reasonable to inexpensive.

AI potential is accelerating

The pace of innovation in the technology sector is leading to massive investment; the enablers and beneficiaries could stand to profit.

AI adoption is the most tangible example today, and it’s already producing results in real time. Take Microsoft: AI most recently contributed double the amount of growth to its cloud business than in the previous quarter.

To support the ongoing growth, Microsoft, Meta, Alphabet and Amazon are expected to funnel massive amounts of capital expenditure to data centers. That investment is expected to bring additional sources of income for the likes of Nvidia (which will round out the Magnificent 7 earnings later this month) and other chipmakers (e.g., Advanced Micro Devices just increased its outlook for its data center CPU from $2bn to $3.5bn). Not only that, but the accelerated pace of adoption of these technologies means that the impact is reaching beyond the tech and tech-enabled sectors.

The bottom line: An active approach may be worth considering

Companies are producing earnings results to validate the rallies they have seen over the past year. And with the largest names in the technology space accounting for a large share of both U.S. and global equity benchmarks, the story matters for all equity investors.

But as these megacap names and the broad equity market continue to grind higher, we think today’s environment makes the case for a focus on “alpha” over “beta” through a more selective approach. More than a third of S&P 500 stocks are still down since the start of 2023, and we see the potential for other themes — such as healthcare innovation and ongoing consumer resilience — to support recoveries in some areas going forward. With a dispersion of earnings results both within and between sectors, careful stock selection can help tap outperformance opportunities. The current environment looks like fertile ground for active equity managers.

Your J.P. Morgan team is here to help ensure that your portfolio is closely aligned with your financial goals and long-term plan for the years ahead.

All companies referenced are shown for informational purposes only and are not intended as a recommendation or endorsement by J.P. Morgan in this context.

All market and economic data as of February 2024 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.

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