A few tech mega-caps — led by Apple, Nvdia, Meta and Amazon — have dominated stock market returns, especially in the last 18 months. This is evident from the diverging performances of the largest 50 stocks in the S&P 500 (weighted by market capitalization), and the average stock of the S&P 500, represented by the XLG
Invesco S&P 500 Top 50 ETF
Invesco S&P 500 Equal Weight ETF
However, in the last few days, this trend has reversed sharply. Mega-caps are selling off while the average stock is holding close to record levels. Investors are trying to make sense of this sudden change.
One explanation is that mega-caps may have become too expensive. Nvidia is a prime example. The company makes the most advanced chips for the calculation-heavy tasks required by AI computing, and by mid-July, the stock had risen by more than 750% in just one year. This surge is not unjustified, as EPS increased by 650% in the last four quarters on exploding revenue.
Other tech companies, such as Meta, Google, and Apple, have also benefited from AI enthusiasm. These companies are thought to be well-positioned to develop, implement, and monetize the promising new technology. They are also largely insulated from higher interest rates thanks to their large cash reserves, which make them independent of external financing and generate additional investment income.
These companies’ uniquely privileged position in the market is why their stocks appreciated so much, while others faced a relatively soft environment and relied more on increasingly expensive financing. No wonder that the stock prices of the mega-cap tech titans opened an enormous gap relative to everything else.
But the market is now questioning how long they can continue to grow at the same rate and whether analysts have been too optimistic in assessing their outlook.
For example, the median analyst projection for Nvidia’s revenue and EPS between 2024 and 2026 is for both to triple. While the chip maker has recorded enormous growth in recent years, it would be a considerable achievement for a company already among the largest by market capitalization to keep growing at the same pace. While the potential of AI is very high, the internet was also a revolutionary new technology. But the enthusiasm it generated in its early stages ended in a crushing bear market between 2000 and 2003. It is possible that too much of the future gains of AI are already baked in, and the stocks are priced for perfection.
Another explanation is that recent economic releases keep showing that inflation is coming down, which may finally prompt the Fed to start cutting rates soon. Meanwhile, while the labor market seems to be softening (albeit from a very tight condition), the economy remains strong, with the most recent numbers for industrial production, housing starts, and retail sales all exceeding expectations.
A combination of lower rates and a steadily improving economy would be ideal for the more traditional stocks, which have been largely ignored by investors dazzled by the tech giants. Many of those stocks are now rather cheap in terms of traditional valuation metrics, and with lower yields on money market holdings it seems logical that investors would turn their sights to those opportunities.
In sum, the rotation may be happening either because tech stocks are too expensive or because others are too cheap. If the former, the next few months are likely to be choppy as market participants struggle with declines in their favorite equities. If the latter, all stocks could benefit, but the average stock might be in a better position to deliver returns.
There are reasons to believe that the second, more positive outcome is more likely. Volatility has been low, and diverging sector performance means that the correlation among sectors is also low. Both conditions are associated with rising markets. Add lower interest rates pulling new money out of money markets and into stocks, and all the ingredients are there for a sustained rise of the stock market to even higher levels.
Of course, many factors could disrupt this outlook. Significant changes in U.S. economic policy or global tensions affecting supply chains are just two examples. But investors always have plenty of reasons to worry, and yet the stock market often finds ways to keep going up.
It may be too soon to say what this week’s markedly different market tone represents or whether it is the prelude to a lasting change. However, the divergences that have been building up may have reached an extreme from which they have stepped back. Alert investors should prepare for the possibility that the leading stocks in the U.S. equity market may look quite different in the coming months.
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