There is no question that the US stock market is currently being dominated by just a handful of stocks — seven to be precise, going by the moniker of the “Magnificent Seven” (coined by analysts and news media). It is this group of mega caps that has been the primary driver behind the S&P 500’s all-time record high levels — accounting for 62.1% and 40.1% of gains in 2023 and so far this year, respectively. Without the Magnificent Seven, market gains would have been far more tempered. In fact, the broader market consolidated in 2H2023, before rising anew (see Chart 1).
The Magnificent Seven now account for almost 30% of the total market cap for all the S&P 500 companies. This is the highest market concentration (in terms of the market caps of the seven-largest companies as a percentage of total market cap) since the 1980s, at least (see Chart 2). No doubt this rising trend is due, at least in part, to the growing popularity of index-linked exchange-traded funds (ETFs). As the market caps for the top performers rise, demand for their shares from passive funds will have to grow in tandem, resulting in even higher prices.
To give some sense of perspective on their outsized impact, the combined market cap for the Magnificent Seven has now topped US$13 trillion, nearly twice as large as the entire market cap for Japan’s stock market. Little wonder that this has triggered a growing debate on whether such a high level of market concentration has significantly raised the risks for not only the US but also global markets.
The domination of ETFs and the spectacular performance of just a handful of companies have resulted in the deepening of “concentration risk”, contrary to the very theoretical advantage of portfolio diversification. This will likely be another painful lesson in the future.
See also: Education lies in the heart of our nation’s problems and the pathway to our solution
Throughout the past year, analysts have played down such risks, arguing that the rally will eventually broaden out, as the rest of the market catches up. That has yet to happen. In fact, the rally has narrowed even further in recent weeks. With share price gains for Apple, Tesla and Alphabet (parent company of Google) in the red for the year to date, the Magnificent Seven is now, in effect, the “Fantastic Four”, of which Nvidia is, by far, the biggest winner — and driver for the S&P 500’s 6.5% gains so far this year. Its share price is up 73.6% (at the point of writing). This is almost double Meta’s price gain of 38.5% and well above gains for Amazon (14.6%) and Microsoft (7.1%). The gap in performance is even more stark going back to the start of 2023 (see Chart 3).
The narrowing rally is likely due, in part, to the paring back of market expectations for early and big cuts in US interest rates — on the back of stronger-than-expected economic data and even signs of resurgent inflation. Based on current fed fund futures pricing, the first interest rate cut is now pushed back to June 2024 from March previously, and the total cuts reduced to 75 to 100 basis points (bps) by year end, down from as much as 150bps. An upward revision to interest rate expectations would have reduced the discounted cash flow values (and prices) for stocks across the board.
See also: The pendulum swings right: A pushback against liberal, progressive, interventionist economics
To a certain extent, therefore, the question as to whether this rally is sustainable or if valuations are already overstretched is where Nvidia stands. The trailing price-to-earnings (PE) ratio for the S&P 500 index is now 24.4 times, at the high end of its historical range in the past three decades, though still lower than during the dotcom bubble and pandemic meme stock mania (see Chart 4). The Magnificent Seven as a group is trading at valuations that are higher than the market average, but this is on account of their higher earnings growth relative to the other 493 stocks (see Table 1). The rest of the market is also expected to grow, but at a much slower rate — trailing PE is around 22 times, just slightly higher than the long-term average of 20 times for the broader market.
Valuations for Nvidia appear reasonable relative to its expected 12-month forward growth, and compared with the rest of the Magnificent Seven stocks (see Table 2). The issue, though, is how does one value a stock that is growing at the pace of Nvidia, of more than 400% in the last 12 months? Because its intrinsic value is, of course, not simply the growth in the next year or two, but over the longer term.
All businesses go through the S-curve of growth, from start-up to maturity — and each new cycle of growth is created with new products, services, markets, business models and so on. Nvidia’s current surge in earnings growth is due to a new S-curve, created by demand for its chips driven by generative artificial intelligence (AI) applications, first triggered by the launch of ChatGPT in November 2022.
The company has repeatedly beat and raised market expectations over the past few quarters, underpinned by robust demand from data centres. But can it continue to grow at the blistering rate? Some analysts have noted that wait time for its high-end AI graphic chips (graphics processing units or GPUs) has fallen to about three to four months from eight to 11 months previously, which could suggest slower future growth. Demand for the semiconductor sector is, historically, cyclical. Plus, there are other factors such as competition (for instance, from AMD and Intel, while the likes of Apple, Amazon and Google are designing their chips in-house) that would reduce future market share and margins. On the other hand, the world is at the early stage of the fourth industrial revolution, and there is a long runway as far as spending on AI is concerned, including demand for chips.
For more stories about where money flows, click here for Capital Section
Your answer as to whether Nvidia’s current growth rates are sustainable and therefore, if the stock is “expensive” or “cheap”, depends on where you think it is now on the S-curve and, importantly, the longevity of its S-curve. Costco, for instance, has a relatively long S-curve (growth played out over many years) while Cisco (the darling stock during the dotcom bubble) and Meta have shorter ones. And then there are businesses with very little economic moat (enduring competitive advantage such as intellectual property and network effect) like Beyond Meat and Peloton (see Chart 5). Bear in mind that the S-curve is dynamic, that is, businesses will continuously reinvest and create new S-curves, to start new growth cycles.
We suspect that Nvidia’s S-curve — as with those for most digital and tech businesses — will also be relatively short, because innovation and technological advancements are happening at a faster and faster clip. In other words, if Nvidia’s growth rate starts to slow within the next, say, five years, then its current valuations are high relative to growth (see Chart 6). Growth will surely slow — just when is the unknown right now.
The Malaysian Portfolio fell 1.9% last week due to continued selling pressure on Insas (-1.8%) and Insas-WC (-8.9%) as well as profit-taking on UOA Development (-6.3%) and Mapletree Pan Asia Commercial Trust N2IU (-4.7%). Oversea-Chinese Banking Corp (+1.1%) and DBS Group Holdings (+0.1%) were the two gainers in our portfolio. Total portfolio returns now stand at 188.8% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 16.3%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
