Sentiment turned in mid-July, more precisely with the inflation report of July 11, 2024, which made it clear that inflation was falling faster than expected, opening up room for the US Federal Reserve (Fed) to cut interest rates earlier than expected. Thus, it was an opportune moment for professional investors to take unrealized gains in (simply put) mega-cap tech stocks and reinvest them in potential winners of the rate cut cycle, namely small caps and value stocks. In our view, however, this explanation offered by the media falls short. The following aspects play a role in the current market phase and explain, at least in part, the temporary weakness of the "Glorious 7":
1. historical growth rates are hard to maintain
While the Glorious 7 were still able to record 31% profit growth in 2023, normalizing growth of "only" around 20% is expected for the coming quarters. At the same time, sales growth is declining, in some cases towards 10% - which is still very solid given the size of these companies, but no longer comes close to the figures from the hype of the past 12 months.
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2. US consumption weakens after a strong 2023
The often-cited and highly confident US consumer is showing increasing weakness. This is reflected in most fundamental data and now also very clearly in the annual reports of companies active in cyclical and non-cyclical consumption. Down-trading, i.e. the tendency to buy cheaper substitute products, is now widely accepted. In addition, consumer-related default rates for credit cards and car financing have recently doubled to 2011 levels (!).
While this is certainly relevant for the broader market and especially for the non-cyclical and cyclical consumer sectors, the current growth of the major tech stocks is characterized by its B2B nature. In other words, the promising semiconductor components and cloud services, which generate high margins, do not necessarily depend on the mood of the end consumer.
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3. how much patience do AI investors have?
Since the release of OpenAI's ChatGPT in March 2023, AI has been the dominant theme in the US and global stock market. The biggest winners have been companies that have managed to position their products and services in the AI value chain, whether cloud, semiconductor components, semiconductor manufacturing equipment, server capacity or cybersecurity.
At the moment, however, investors are growing impatient. Can the breathtaking investments made by the tech industry and the so-called hyperscalers in particular ever really pay off? To make matters worse, the current higher interest rates make it necessary to think about opportunity costs again. Every year that these investments fail to generate profits, investors could generate between 3 and 5 percent returns on the bond market, and with significantly less risk.
4. growth at a reasonable price?
Of course, the AI hype has led to an unprecedented rally in selected tech stocks. The 10 largest companies currently represent more than 35% of the S&P 500 - an unusually high concentration historically. Valuations skyrocketed, at times reaching 30 times next-12-month earnings (price-to-earnings ratio) (the historical 30-year average for the S&P 500 is 16.7).
Even within the Glorious 7, however, there are massive differences here - the valuations of Meta and Alphabet are below 23, while those of Tesla (which is no longer considered "glorious" by some due to structural weakness in the global electric vehicle market) are 77. At the same time, the valuations of some traditional companies far removed from AI are in some cases well above historical experience (industrials +26%, healthcare 27%, financials 21%), so while the "overvaluation" of tech stocks clearly exists, it also applies to other sectors.
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5. you can't have enough tech in your portfolio - can you?
On the one hand, the sheer size of the Glorious 7 means that they can hardly be overweighted by traditional asset managers in diversified portfolios. As a result, the majority of US equity managers, who are often more broadly diversified, underperformed their benchmark indices in 2023. (Source: S&P Global, as at 31.12.2023). On the other hand, in the perception of global fund managers, betting on the Glorious 7 has been the most crowded trade in every month since April 2023. The potential for a setback in the event of a change in sentiment was therefore correspondingly high.
6 Not all tech is the same
Within the tech industry, there are promising business models outside the Glorious 7 across various market capitalizations that benefit from cyclical or structural trends. Recently, selected payment service providers, chip manufacturers and hardware manufacturers, among others, reported excellent figures. It is therefore still worth actively looking for attractive and innovative companies in the tech sector.
7 Interest rates & tech
Even if "duration" is generally a term from the world of bonds, equities also exhibit resilient sensitivities to interest rates. This is intuitively understandable in the case of banks and financial stocks, which earn directly from the shape of the yield curve. However, there is also an empirically verifiable correlation for the technology sector: if investors expect the Fed to start a cycle of interest rate cuts in September (supported by similar trends in the rest of the world, excluding Japan), this should provide a certain tailwind for the technology sector.
Conclusion:
A sector rotation has recently caused significant dislocation in the equity market and the generally accepted media narrative falls short in our view.
Rather, AI-related companies are reaching a phase in which not only growth rates are declining, but also companies' patience is slowly being tested. We are still convinced that the technology sector offers attractive growth opportunities, but in the current phase also outside the Glorious 7.
Note: Marketing advertisement - All information published here is for your information only and does not constitute investment advice or any other recommendation. The statements contained in this document reflect the current assessment of DJE Kapital AG. These may change at any time without prior notice. All statements made have been made with care in accordance with the state of knowledge at the time of preparation. However, no guarantee and no liability can be assumed for the correctness and completeness.