- High bond yields, coupled with recession fears, have spurred investors to sell this fall.
- The so-called Magnificent Seven have pulled back as well, but that could be a buying opportunity for investors.
- Goldman Sachs outlines how high earnings and low valuations could send the mega-cap tech elite even higher.
The majority of the market’s gains year to date have come from a small group of large stocks, and they don’t appear to be slowing down anytime soon. According to Goldman Sachs, at least.
The Magnificent Seven — Nvidia, Apple, Amazon, Alphabet, Microsoft, Meta, and Tesla — have been driving the S&P 500’s startling rally since the first quarter of this year.
However, those seven stocks have recently stumbled. Goldman Sachs chief US equity strategist David Kostin noted in a note to clients earlier this week that shares of the Magnificent Seven have fallen 7% since the beginning of August, compared to a 3% drop in the S&P 500.
According to Kostin, the recent slump will not last. In fact, it may provide investors with an ideal opportunity to purchase shares in some of the market’s largest and best-positioned companies at a discount.
Bond yields will settle down soon enough
Big tech took a hit in 2022, but the Magnificent Seven roared back to life in 2023 thanks to the artificial intelligence hype.
Nvidia’s Q1 announcement that sales would far exceed Wall Street’s wildest expectations due to artificial intelligence signaled to the rest of the market that any stocks even remotely related to the buzzy new technology were worth investing in.
The results speak for themselves: Nvidia shares led the group higher, rising 218% between January 1 and August 1, while Microsoft shares trailed behind, rising only 40% through the beginning of August.
Bond yields rose as the summer came to an end. The Fed’s threat to keep interest rates higher for longer drove bond yields sharply higher in a short period of time, raising the prospect of a recession once more.
The 10-year US Treasury yield has risen from 4% in early August to 4.7% today, reaching levels not seen since 2007. The rise has coincided with a sell-off in equities, which has impacted Magnificent Seven shares, though Kostin says this is to be expected.
“The underperformance of the largest long duration tech stocks in the face of soaring Treasury yields is consistent with the trading pattern of the last five years: The largest stocks have tended to struggle in the face of greater than 50 bp increases in the nominal 10-year yield over two months,” he wrote in a note.
Kostin also believes that bond yields will not remain this high indefinitely. Despite popular belief, Goldman Sachs economists believe the Fed will not raise rates again in 2023, according to Kostin, and the firm’s strategists predict 10-year yields will settle around 4.3% by year’s end.
A fantastic time to buy the dip
Higher bond yields hurt the Magnificent Seven’s shares, according to Kostin, while also lowering their valuations.
“The NTM P/E of the 7 largest mega-cap tech stocks has fallen by 20% in aggregate – or 7 full turns – in just the last two months (34x to 27x),” Kostin wrote in an email. He followed up with the following statement: “The largest stocks now trade just 14% above their median P/E multiple since 2014 (24x, Exhibit 1).”
Rising bond yields were a major factor in the decline of big tech valuations, but if bond yields do fall as Kostin predicts, the downward pressure on the Magnificent Seven’s valuations will be relieved, giving shares room to rise.
However, valuations are not everything. While the “P” in P/E is important, earnings are also important — and the Magnificent Seven are still in a class of their own in this regard.
“While the balance of the S&P 500 grew revenues at a much more comparable clip in 2021 and 2022, consensus expects the S&P 493 to grow sales at a 9 pp slower annual rate than the largest tech stocks through 2025 (3% vs. 12%, Exhibit 8),” Kostin wrote in a note. “On an earnings basis, the largest 7 are expected to grow profits 15% through 2025 as compared with 5% for the remainder of the index.”
Taken together, today’s lower valuations and tomorrow’s earnings growth are a potent combination, especially given Wall Street’s belief that the Magnificent Seven’s profits will only rise in the coming years.
“In aggregate, consensus now expects the mega-caps to grow earnings by 22% over the next 12 months and 43% over the next 24 months,” Kostin wrote in an email. “The recent upgrade to consensus estimates in part reflects the largest tech stocks growing into their elevated P/E multiples – especially NVDA and AMZN.”
Purchase large stocks at a low cost.
One and two-year forecasts are fine, but Kostin believes investors have an opportunity right now due to the upcoming third-quarter earnings season.
“History suggests the upcoming earnings season is a potential catalyst for the largest tech stocks,” he wrote in a note.
Kostin claims that big tech stocks have outperformed the S&P 500 in two of the last three earnings seasons since 2016. Analysts agree that this earnings season will be another winner for big tech, with expected sales growth for the group outpacing the rest of the S&P 500.
And for investors concerned about price, Kostin has good news: shares of the Magnificent Seven are at their lowest point in six years.
“The 7 largest tech stocks in aggregate trade at a 1.3x PEG ratio (Price / EPS / Long-term growth) as compared with 1.9x for the median S&P 500 stock, the largest discount since January 2017 and a level that has been reached only five times in the last decade (0.70x, Exhibit 9),” he wrote in a note.
With higher sales and earnings expectations propelling shares skyward, Kostin believes the Magnificent Seven could enjoy shockingly strong appreciation from current levels.
“If consensus growth estimates remain unchanged and the mega-cap tech stocks do trade back to their average PEG of the last decade (0.84x), the group would appreciate by 20%,” wrote Kostin in a blog post.
It may appear strange to believe that a group of stocks that have gained 92% year to date could gain another 20% from where they are now, especially as the S&P 500 falls. Higher bond yields and a struggling market, on the other hand, are masking a combination of opportunities for the Magnificent Seven that investors can’t ignore: low valuations, long-term earnings growth, and the unprecedented benefits of being first in the AI race.