Han Dieperink: The Magnificent Seven, great promise or bubble?
This column was originally written in English. This is a Dutch translation.
By Han Dieperink, written in a personal capacity
The 2023 stock market will be dominated by the Magnificent Seven. These seven stocks rose to year-to-date highs last week thanks to new all-time highs for Microsoft and Nvidia. There is a good chance that these shares will rise further next year. They benefit from three trends and will soon also meet the four conditions for the formation of a bubble.
Trend 1: Artificial intelligence
A key reason why these stocks may continue to rise is the advent of generative AI. Normally, large companies get in their own way when it comes to innovation. Especially in the field of technology, even the largest companies can be wiped out in just a few years by a company with a better idea. However, this is different with artificial intelligence (AI).
The development and use of AI requires a lot of data. Most data nowadays is concentrated in the cloud and that is also where AI can do something with it. Now, cloud service providers are limited to the large IT companies that are part of the Magnificent Seven. There is also no diminishing return. Bigger is always better.
Trend 2: De facto monopolies
The Big Tech companies in the Magnificent Seven are de facto monopolists, which in most cases has been made possible by disruptive innovations of the past. Nowadays, with the advent of the internet and improvements in the field of commerce, technology is going viral in a short period of time. Where a company used to need decades to build a global network, technology companies can do this in just a few years.
Speed is important, because ultimately the principle of 'winner takes all' also applies here. This means that these companies in particular have no difficulty raising prices with their subscription model. The buyer cannot go to the competitor, because he or she is not there. A possible advantage for next year is that – apart from Amazon – all these companies generate much more than 40% of their turnover outside the United States and therefore benefit relatively from a weaker dollar.
Trend 3: Increasing investments
Investments in technology have become an increasingly large part of average business investments in recent decades. These investments do come in cycles. During the corona crisis, there was a lot of investment, because everyone suddenly started working, shopping and studying from home. This year (post-corona), investments are therefore at the lowest point in the past 14 years.
Yet the need to invest is great and this is partly due to the tight labor market. This shortage can be solved with artificially intelligent applications that are already fairly easy to roll out. Because (minimum) wages are rising, there is a clear incentive for entrepreneurs to invest in technological solutions. Moreover, the arrival of Chat-GPT is also a reason for many boardrooms to do more with AI.
Most budgets for 2024 have now been allocated and a large part will go to artificially intelligent solutions. These investments will probably also benefit from the low interest rates next year.
Bubble in the making, four conditions
According to Charles P. Kindleberger (Manias, Panics & Crashes), there are four conditions that must be met for a bubble to form. The current situation surrounding the Magnificent Seven has all four:
1) First of all, there must be a shift in economic reality. That shift comes in the form of AI. While the industrial revolution was about the automation of human muscle power, this IT revolution is about the automation of human brain power. The economic consequences are greater than the arrival of the Internet or the arrival of the iPhone. This also has a greater impact on productivity and therefore on economic growth.
2) This also brings us to Kindleberger's second requirement: there must be a promise in the distant future that is not easy to qualify at the moment. During the dotcom bubble, this was the arrival of the mobile internet, which only made its breakthrough with the arrival of the iPhone in 2007. With AI, we also need some time to understand all the possibilities.
3) Kindleberger's third requirement is that there is a broadening of the investor target group. Until this year, an investment in Nvidia, for example, was reserved for investors who were interested in chip development.
Of course, nowadays there are also large groups of index investors who invest in every company, but for these investors these companies were part of the technology sector and therefore part of the index. Technology is now actually in all sectors: software is eating the world. Amazon is part of the consumer discretionary sector and Alphabet and Meta are in the sector where telecom used to be.
In addition, there are also investors who join the Magnificent Seven as an alternative to defensive companies, under the motto that with such a market position and growth, things will ultimately work out well. In fact, it's a better safe haven to invest in than long-term US Treasury bonds, which have halved in the past three years. Towards the end of the year there is also a growing group of 'tracking error' investors. Given the large dispersion between the Magnificent Seven (+71%) and the 493 other stocks from the S&P (+6%), more and more investors do not want to underweight the Magnificent Seven.
4) Kindleberger's last condition is liquidity: fuel for the stock market. It is still extremely tight at the moment, but that will improve next year. The short-term risk is that defensive investors exchange their poorly performing defensive stocks from the consumer staples, utilities and food sectors for more large tech companies. This gives the flight to the Magnificent Seven a self-reinforcing effect due to the large dispersion between stocks. If liquidity improves next year and interest rates fall, the Magnificent Seven could rise sharply again.
If the Magnificent Seven can maintain its current growth rate, these stocks will outperform the market average next year. After all, nothing can beat a profit growth of 70%. Now, such a percentage is difficult to imagine at these types of large companies, but Nvidia is the first company ever to grow significantly from such a large size. Based on the current profit expectations for the market, it is already clear that these shares will also grow much faster than the market next year, at higher profit margins and with much better balance sheet ratios.
A disadvantage, of course, is that expectations for the Magnificent Seven are high. It certainly does not come across as the ideal 'tip of the week'. Yet all the ingredients for a continuation of the hype are present, especially because the valuation is much lower than in 2000 (Tech's Four Horsemen) or in 1972 (Nifty Fifty). Moreover, if a real bubble forms, then valuation no longer matters.