As Big Tech Profit Growth Slows, Investors Hunt for a New Thing

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(Bloomberg) — The stock market’s growth engine is running on fumes.

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For many years, investors have relied on the largest technology companies to push stock indexes higher based on their strong earnings and expectations for more profits in the future, fueled more recently by the development of artificial intelligence services. Those days appear to be over, at least for now. And it’s forcing investors to think about other ways to play the latest stock bull market as it enters its third year.

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The issue is profits. The seven giant technology companies – Alphabet Inc. – are expected to achieve… and Amazon.com Inc. and Apple Inc. and Meta Platforms Inc. and Microsoft Corp. And Nvidia Corp. And Tesla Inc. Combined profits will increase by 18% in 2025, down from the 34% expected for 2024, according to data compiled by Bloomberg Intelligence. If we exclude Nvidia, arguably the biggest beneficiary of Wall Street’s AI mania, the rest of the group is expected to post a meager 3% increase in earnings in 2025.

An 18% earnings expansion is good news for almost any sector, except Big Tech. If that estimate comes true, the high-flying group would lag behind health care in full-year earnings growth and not far behind the materials and industrials groups.

Meanwhile, S&P 500 earnings growth is expected to reach 13% in 2025, up from 10% this year. In other words, giant tech companies no longer set the pace for corporate America.

“Mag Seven will not necessarily be the growth driver for the market that it has been over the last year or so,” said Julian McManus, portfolio manager at Janus Henderson.

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Investors are already responding. In the week ending Dec. 4, the IT group saw its largest outflow in six weeks of $1.4 billion, according to a note from Bank of America on Friday, citing data from EPFR Global. Small-cap stocks, which have been lagging the broader market this year, generated inflows of $4.6 billion, putting them at an annual record high of more than $30 billion.

McManus said he expects upside surprises in free cash flow growth and sees alternatives to big tech companies around the world, not just in the United States, where he is “significantly underweight.” He likes energy producers, which take advantage of the popular power-hungry data centers, and sees opportunities in biotechnology as well as chip design software companies such as Cadence Design Systems Inc.

A big part of looking for alternatives to big tech companies is just about their stock prices. Just this week, the Magnificent Seven companies traded at 41 times expected earnings, the highest valuation multiple since early 2022, according to data compiled by Bloomberg. The entire S&P 500 saw a jump as well, at 23 times the highest level since 2021. But it’s still roughly half the price of the tech giants’ valuations.

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“You only take too much risk when you’re in the bigger companies,” said Phil Blancato, CEO of Ladenburg Thalman Asset Management. “You’re looking at companies that are trading at very rich valuations. Some of the numbers for the rest of the S&P 500 don’t look bad, they look good. I’d rather buy the rest of the S&P 500 at 18 times (forward earnings) versus the entire S&P 500 at 23 or 24 times.”

He is not alone in his doubts. Wall Street professionals like Michael Wilson, chief U.S. equity strategist at Morgan Stanley, and Brian Belsky, chief investment strategist at BMO Capital Markets, see the stock rally continuing to expand to include sectors beyond big technology companies, a trend that began in the second half of the year. Sunnah.

“The euphoria around big tech is evident in Magnificent 7’s growth forecasts that are near all-time highs, at a time when its earnings are set to slow,” Bank of America strategists led by Savita Subramanian wrote in a note to clients this week. Although the group represents about a third of the weight of the S&P 500, “we see greater opportunities in the average stock than in the index,” the strategists wrote.

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However, this does not mean that all Magnificent Seven stocks are created equal. Because there’s one company that stands above the rest: Nvidia.

Continued demand for its accelerators used in artificial intelligence computing has driven up profits. Nvidia is expected to earn $71 billion on revenue of $129 billion next year, up 49% and 52%, respectively, according to the average of analyst estimates compiled by Bloomberg. Which explains why the stock is the seventh-best-performing stock in the Russell 1000 this year with a 193% gain — and the only Magnificent Seven company among the top 50.

Much of Nvidia’s success is due to spending from its massive peers. Microsoft, Alphabet, Amazon and Meta Platforms are expected to offer more than $200 billion in combined capital spending for 2024 to boost computing power. They have pledged to spend significantly more next year. This is great for Nvidia, but investors are wondering when these investments will pay off for the rest.

“I wouldn’t be surprised to see Mag Seven disintegrate because gravity would catch up with it,” Janus Henderson’s McManus said.

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Of course, Wall Street has underestimated the power of big tech companies in the past. At the start of 2024, analysts were expecting earnings growth of 19% for Magnificent Seven, and the group is now on track for a 34% increase.

Despite the numbers, tech giants still maintain their appeal with investors, especially if the economy deteriorates. Scott Krohnert, US equity strategist at Citigroup, likens the group to a defensive sector like consumer staples, whose products people need regardless of economic conditions. The point is that big companies remain a safe bet in turbulent times – like now.

“If you were going to sell big tech companies, where would you go?” said Andrew Choi, portfolio manager at Parnassus Investments. “Do you really want to bet on interest rate sensitive stocks where you need prices to go in a certain direction? Do you want to chase places that have done well? Big Tech remains the best and easiest answer to what you want regardless of what market conditions end up being.”

—With assistance from Ryan Vlastelica.

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