Can the US share market keep delivering? Spotlight on the ‘Magnificent Seven’

One of the most intriguing things to consider about markets as we get closer to the end of the year is whether the US market can continue producing such stellar returns.

Such considerations used to involve looking at various sectors to arrive at some sort of overall prediction but the US market has changed so much over the past few years that the really big question is what will happen to the handful of companies known as the “magnificent seven.’’

Together, these giant, fast growing technology companies have played a massive part in pushing the S&P 500 index higher and at the same time, they have become a much larger chunk of that overall index as well.

The seven mega tech companies are Nvidia, Apple, Microsoft, Amazon, Meta, Alphabet and Tesla, although there is some debate about whether Tesla truly belongs with the others.

Magnificent seven reporting strong profit growth

Their most recent profit reports were exceptionally strong, with revenues jumping for search, advertising and e-commerce with cloud storage particularly strong as AI drove revenues higher.

All seven companies, to varying degrees, have produced rapid profit growth and have been rewarded with incredibly generous valuations.

As a consequence of this increased size and growth profile, they now make up around a third of the value of the S&P 500 – a massive concentration that investors are unaccustomed to dealing with in this usually highly diversified index.

Success has led to a more concentrated index

To some extent the continued growth of the magnificent seven is inter-related, with Nvidia providing many of the chips that the others use to keep the AI party going.

In an investment sense, though, there is plenty to worry about with the growth rates of the seven companies still above average but no longer dramatic enough to continue the accelerating valuations into the future.

Indeed, US brokers are now forecasting that the seven mega-cap companies will perform just slightly ahead of the other 493 companies that make up the S&P 500.

Net income growth for the seven is predicted at around 20% compared to around 16% for the remaining companies – potentially not enough of a gap to justify the premium prices investors need to pay for exposure to the ”magnificent” group.

Can the rump companies play catch up?

In valuation terms, the magnificent seven are trading at around 30 times blended forward earnings while the rest of the S&P 500 companies are closer to 19.5 times, suggesting that there is plenty of potential for the large non-magnificent rump to play catch up in the coming year.

Much will depend on the continuing progression of generative AI in driving efficiency gains across many other businesses but history would suggest there is little room for disappointment if the tech rally is to continue at the frantic pace it has assumed over the past couple of years.

Given that all seven are heavily linked to the AI tech boom, reducing exposure to this trend seems like a sensible move but a difficult one if you use passive investment vehicles such as S&P 500 ETF’s to gain exposure.

There are ways to reduce technology exposure

One idea that might provide some protection against tougher times for if the magnificent seven become something less than magnificent is to use a S&P 500 equal weight ETF such as the Betashares version (ASX: QUS).

By giving equal weight to every company on the S&P 500, this will greatly reduce the concentration of the magnificent seven down from around 30% of the index to around 1.4%.

It also offers much greater exposure to smaller companies in the S&P 500, which could hopefully coincide with a broadening out of the US share rally to smaller companies.

Another way to get broader exposure to smaller US shares would be to use Vanguard’s US total market shares (ASX: VTS), although that will still deliver around 70% of its exposure to large US companies, due to their high market cap weighting.

Of course, it is also possible that the magnificent seven will continue to push the overall market higher and that reducing exposure to them could be a big mistake.

It is totally a judgement call and sometimes rally trends can last much longer than expected.

The one constant that has held in recent years is that the US market is one of the most important growth engines in the world and it would be a brave investor indeed who chose to ignore the world’s largest and most innovative index.

To what extent that includes exposure to the magnificent seven is debatable but in terms of capital growth and exposure to trends such as the AI boom, there really is little alternative to the S&P 500.