Bloodbath

Stock investors this week saw some fairly hefty declines on Wednesday, July 24. The S&P 500 was down 2.3%, its first daily drop of more than 2% since December 15, 2022. The Nasdaq fared even worse, falling 3.6% on the day. And then there were the Magnificent 7 stocks, which sustained an average decline of 5.6%. But the weakness in the Mag 7 didn’t begin yesterday. On average, the Mag 7 stocks have now registered a 12.3% decline in market capitalization from their respective 52-week highs (through the July 24 close). That may not seem like much given the run these stocks have been on, but the losses are far from immaterial. If we add up the market cap losses for the Mag 7 stocks, the total comes to nearly $1.9 trillion. That’s a lot of money.

Where do we go from here? It’s hard to say. But what is clear is that even after the big losses sustained through trading on July 24, the Mag 7 still have a huge amount of influence over the stock market at large. In fact, the Mag 7 stocks still accounted for 31.2% of the S&P 500, as of the July 24 close. That leaves the other 493 S&P 500 stocks accounting for just 68.8% of the overall index (for an average weighting of just 0.14%). We’ve written frequently over the past several months that for the stock market to continue its winning streak, we will need to see broader participation beyond just the mega-cap stocks. Well, so far, the Mag 7 losses are outweighing the performance of the remaining 493 stocks, and the S&P 500 is getting very close to a 5% correction.

My long-time partner John Washington used to say that trends can last longer than anyone expects, and I wholeheartedly agree. But what we are learning this week is that at some point valuations and fundamentals matter. The Mag 7 stocks are all clearly incredible companies with bright futures. But trees don’t grow to the sky, and at some point, companies can grow so large that growth rates become much harder to sustain. Yes, the development of AI should act as a tailwind for Mag 7 earnings. But that growth potential has costs, and the heavy costs required to develop these new businesses will likely drag earnings over the near to intermediate term. I think investors are finally starting to grapple with that reality, and the weakness in the Mag 7 stocks may not necessarily be anything more than a healthy reset of expectations. That said, it’s impossible to say whether or not a 12% average decline from nosebleed levels will be enough of a reset.

For its part, Alphabet said the quiet part out loud on its conference call regarding AI capex. It views the risk of underinvesting is dramatically greater than the risk of overinvesting. If they are indeed overinvesting, the infrastructure will eventually be useful to them as it has a long useful life. For most of the Mag 7, the ramp up in investments that started in the fourth quarter of last year will be starting to flow through depreciation expense, creating some cost inflation for companies that, prior to this, were focused on efficiency and headcount reductions (margins). No company has really quantified the long-term monetization potential thus far, so to the extent that you see costs before significant revenue, investors get nervous.

Hang in there.