The Mag 7 becomes the Mid 7
Our groundbreaking research in 1995 showed that style, size, quality, and sector rotations are more influenced by profits cycles than by economic cycles. Investors take more risk, and markets broaden when profits cycles accelerate, but they become more conservative when profits cycles decelerate and really hunker down during profits recessions.
Market leadership naturally narrows during periods which profits decelerate because markets become “Darwinistic”. Performance becomes a function of survival of the fittest during profits recessions, and the fewer and fewer companies that can maintain earnings growth outperform as the profits environment deteriorates.
2023/2024 leadership, dominated by the so-called Magnificent 7 (Mag 7), was the narrowest market since 1998/1999’s Technology Bubble (see Chart 1). Goldman Sachs[1] has suggested the Magnificent 7 effect caused the narrowest market since the Great Depression.
Narrow leadership during the Depression seems very justifiable because companies were fighting to survive let alone have meaningful earnings growth. However, the recent narrow leadership occurred during healthy economic and profits growth, and therefore, seems more like the speculative period of the Technology Bubble than the justifiable period of the Depression.
Don’t abandon the financial plan because of narrow leadership
Financial plans are akin to an investment policy statement of an endowment, foundation, or pension. Such plans outline strategic asset allocations, risk tolerances, expected returns, and cash flow needs to meet various near-term and longer-term goals.
Financial plans serve two purposes. First, they are supposed to maintain the risk profile of an individual’s portfolio when perceived risks are high. Investors might prefer to avoid risk during such periods, but doing so reduces the probability of meeting stated investment goals and cash flow needs.
Perhaps more important in the current environment, financial plans are supposed to rein in investors when they are taking too much risk. It might seem exciting or even financially rewarding to take excessive risks during such periods, but riskier investments’ volatility ultimately returns and can damage the corpus of the portfolio making the achievement of longer-term goals considerably more difficult.
Narrow markets seem to encourage speculation and lead investors to avoid diversification. The temptation of “running with the bulls” in an asset class, market, or equity market segment is often too alluring to ignore. The financial plan is intended to protect an investor from their emotions, whether an investor is scared or emboldened.
Mag becomes Mid
The Magnificent 7 might have been magnificent, but they certainly haven’t been unique. Some have claimed the Magnificent 7’s outperformance has been attributable to the companies’ superior earnings growth, but our research has repeatedly shown that such claims seem exaggerated. There have been many other US and non-US companies with equal or better earnings growth that investors have largely ignored.
The similarity between the growth prospects of the Mag 7 and the growth prospects of the remainder of the global equity market that investors have ignored has now started to favor the remainder of the market. In other words, the Magnificent 7 can now be considered average growers!
Each bar in Chart 2 represents an S&P 500® company that is forecasted to grow 25% or more over the next 12 months (NTM). There are plenty of S&P 500® companies with such growth potential, but only one of the Magnificent 7 passes that screen.
That one company is Nvidia[2], and if one removes it from the Mag 7, the median forecast for the NTM earnings growth for the remaining 6 stocks is only 10%. The same median growth forecast for the remaining 493 companies within the S&P 500® is 9%.
Using the Gen Z term, the Mag 7 has officially become the Mid 7.
International Quality has a superior expected return
The addition of dividend yield and forecasted earnings growth is a basic way to forecast expected returns. Of course, one should also consider valuation when assessing potential returns, but the Magnificent 7 is expensive relative to virtually any other grouping of stocks. Valuation, therefore, becomes somewhat moot relative to yield and growth.
Chart 3 shows the dividend yield/projected earnings growth combinations for selected equity groups. Groups in the “northeast” of the chart (i.e., higher yield and stronger growth) would be considered more attractive, whereas those in the “southwest” would be less attractive (lower yield and weaker growth).
There are several important points embedded in the chart:
The most attractive segment of those presented is International Quality. It is the most northeast of the groups because it has the highest projected earnings growth rate and the 4th highest dividend yield.
There are several groups that offer competitive expected returns to the Magnificent 7’s. Materials, Financials, and Industrials all have similar projected earnings growth but also offer higher dividend yields.
The Magnificent 7 is a remarkably unattractive group given the attention the group gets from investors.
Valuation does matter
Value factors into every purchase one makes. The clothes one wears, the restaurant one eats at, the shop one buys coffee at, and the mechanic who fixes one’s car are all chosen based on a value proposition of price versus anticipated result.
If one were offered a Rolex for the price of a Timex, a Maserati for the price of a Chevrolet, or a pair of Manolo Blahnik shoes at Hush Puppy prices, one would probably quickly buy the luxury good thinking they just received a huge bargain. Conversely, no one would ever consider buying the reverse of those hypotheticals.
Right now, a lot of stocks are “on sale” within the global equity markets. Chart 4 shows the median price/earnings ratios of each equity market segment highlighted in Chart 3. International Quality is not only expected to grow faster and have a higher dividend yield than the Magnificent 7, but the category is also considerably cheaper. Whereas the Magnificent 7 has a median PE of 33, International Quality’s PE is about 23. Sectors like Industrials and Financials that offer similar growth to the Magnificent 7 are also selling at more conservative valuations.
The Rolexes and Blahniks might be on sale.
Profits are starting to decelerate
The US and many global profits cycles are starting to decelerate, and the equity market segments that traditionally outperform when profits accelerate are typically not those that outperform when profits decelerate.
Historically, quality has been a dominant factor when profits decelerate and, as the previous charts outlined, quality and defensiveness is currently undervalued relative to the popular Magnificent 7 and offers similar or even better growth than the Mag 7.
These are now the main themes embedded in our equity portfolios.
Mag becomes Mid. Mid becomes Mag?
The Magnificent 7 have become an expensive group that seem to no longer be unique. Other market segments, like International Quality, now offer superior growth prospects, higher dividend yields, and cheaper valuations.
It appears that Magnificent has become Mid, and Mid has become Magnificent.
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