'Magnificent 7' stock mania is drawing comparisons to the dot-com bubble

The AI hype may be new, but investors pouring into high-flying tech names has run its course before.

The Magnificient Seven tech stocks, coined by Bank of America analyst Michael Hartnett, are comprised of Apple, Alphabet, Microsoft, Amazon, Meta, Tesl, and Nvidia. They are involved in hardware and software, artificial intelligence and cloud computing, and are seen by investors as powerful engines for new technologies that power the economy and enmesh themselves in the lives of billions of people.

The amazing rise of the "Magnificient Seven" bears resemblance to bubbles of the past, which analysts say carries risks for late-arriving investors who stand a lower and lower likelihood of generating strong returns as prices climb. Parallels to the dot-com boom in the late 1990s and the eventual bust that followed - who could forget Pets.com and Webvan? - have gained renewed attention.

In the early 2000s the Fed had been in tightening mode, real yields were elevated, and while central bankers did eventually ease policy aggressively, it failed to calm a jittery equity market, said Nicole Tanenbaum, partner and chief investment strategist at Chequers Financial Management.

The divergence between the biggest tech stocks on Wall Street and the rest of the S&P 500 continues to grow, drawing comparisons to the inflated valuations of tech companies in the dot-com era.

Research from Goldman Sachs shows the S&P 500 has never been this top-heavy, which is leading to gains in a handful of stocks, the "Magnificent Seven," driving the index higher. (Goldman Sachs Global Investment Research).

The "Magnificent Seven" are up 80% this year. And when they are stripped out of the S&P's growth, the rest of the index is basically flat, according to an analysis by Apollo Global Management's chief economist Torsten Slok.

"AI is the latest shiny new toy," Slok said of Wall Street's excitement behind the growth of the Magnificent Seven, whose valuations are beginning to look similar to those of the tech bubble in 2000. The 7 companies have an average P/E ratio above 50. The average ratio for the leaders during the dot-com crash was 63. (Disclosure: Apollo is Yahoo's parent company.)

Fueled by a wave of cost cutting and hype around the transformational potential of AI, valuations are overstretched as investors cheer on the rally led by AI. The mega-cap stocks trade at substantial premiums to the rest of the market.

Because of the Magnificent Seven's outsized role on Wall Street, a potential downturn carries broad risk.

These 7 companies have become so large that many investors have exposure to them. A correction in their share prices could broadly impact investors around the world.

While similarities warrant our attention, analysts also say there are substantial differences between the dot-com bubble and the rise of the Magnificent Seven. Fundamentals are chief among them.

"The current crop of high flyers boast higher profit margins, faster growth, and healthier balance sheets than their predecessors, which helps to justify their premium valuations to the rest of the market and positive earnings momentum," said Tanenbaum.

Viewing the financials of highly profitable companies such as Apple and now-defunct '90s darlings, like Pets.com, offers a striking contrast, she said. Back then, startups with unproven business plans achieved multibillion-dollar market valuations. In the current period, the tech giants are firmly established in the global economy, touting operations that span multiple industries.

Another basic difference between the two eras is the context of market trading. Some of the run-up investors have seen in 2023 has arguably been a reversal of the sharp pullback that mega-cap tech experienced in 2022.

And even if a slide occurs, the market can still offer strong returns when its leaders lose momentum.

Since 1990, the S&P has averaged a return of more than 14% in the year after peaks in the relative performance of its 10 largest stocks, according to a new analysis by BMO Capital markets, led by Brian Belski. Since a handful of mega-cap stocks are on track to have one of their best years relative to the hundreds of other companies in the index, it's unlikely that the trend can continue into next year. "Smaller" is likely to be a key investment theme in the quarters ahead, the co-authors argue in their 2024 market outlook.

As many of the largest stocks that drove performance are unlikely to maintain the same momentum in 2024, investors will be forced to "search for other opportunities further down the market cap spectrum,” they wrote. Small cap stocks which underperformed, may outperform next year.

For now, the party is still raging, which calls for caution.

Like any stock that has experienced significant gains over a sustained period of time, there is a risk of a correction to more normalized or average levels. No stock outperforms forever.