Wall Street's "Magnificent Seven" May Be a Mammoth Liability for the Stock Market

When the going gets tough on Wall Street, investors have often turned to time-tested businesses that offer a history of outperforming the broader market. In 2023, the "Magnificent Seven" fits that definition perfectly.

When I refer to the Magnificent Seven, I mean:

• Apple (NASDAQ:AAPL)
• Microsoft (NASDAQ:MSFT)
• Alphabet (NASDAQ:GOOGL)(NASDAQ:GOOG)
• Amazon (NASDAQ:AMZN)
• Nvidia (NASDAQ:NVDA)
• Tesla (NASDAQ:TSLA)
• Meta Platforms (NASDAQ:META)

Image source: Getty Images.

The Magnificent Seven stocks do two things really, really well. To begin with, they bring well-defined competitive advantages to the table.

• Apple is the leading smartphone provider in the U.S., and its capital-return program, which has delivered around $600 billion in aggregate buybacks since the start of 2013, is unmatched.
• Microsoft's Windows operating system still dominates on personal computers, while Azure is the global No. 2 in cloud infrastructure service sales.
• Alphabet's Google has accounted for at least 90% of worldwide monthly search share for over eight years, while YouTube is the global No. 2 among most-visited social sites.
• Amazon accounts for around 40% of U.S. online retail sales and owns Amazon Web Services, the global No. 1 in cloud infrastructure service sales.
• Nvidia is being fueled by artificial intelligence (AI) excitement and is expected to hold about 90% of the share for AI-driven graphics processing units used in high-compute data centers.
• Tesla is North America's leading electric-vehicle (EV) manufacturer and the only pure-play EV maker that's producing a recurring profit.
• Meta Platforms owns the top social media real estate on the planet and attracted 3.88 billion monthly active users during the June-ended quarter.

AAPL data by YCharts.

The second thing the Magnificent Seven have a penchant for is outperformance. These seven stocks have been virtually unstoppable since the green flag waved in 2023.

But while everything appears great for the Magnificent Seven on the surface, this small group of outperformers may be a mammoth liability for the stock market.

History hasn't been kind when the major indexes are highly concentrated

On one hand, these seven companies (eight securities, counting Alphabet's two classes of shares) have singlehandedly lifted the benchmark S&P 500 (SNPINDEX:$SPX) and Nasdaq 100 to phenomenal year-to-date gains of 12.5% and 34.4%, through Sept. 22, 2023. On the flip side, the equal-weighted S&P 500 is up by a mere 1% on a year-to-date basis, suggesting that the rest of market isn't thriving.

As of the closing bell on Sept. 22, the 10 largest S&P 500 components made up a historically high percentage of the benchmark index's weighting:

• Apple: 7.046478%
• Microsoft: 6.544554%
• Amazon: 3.23713%
• Nvidia: 2.792888%
• Alphabet (Class A, GOOGL): 2.13343%
• Tesla: 1.946472%
• Alphabet (Class C, GOOG): 1.827586%
• Berkshire Hathaway (Class B, BRK.B): 1.82635%
• Meta Platforms: 1.811949%
• UnitedHealth Group: 1.279699%

For those without calculators, or a desire to go five decimal places deep, we're looking at the 10 largest-weighted stocks in the S&P 500 comprising about 30.45% of the index's total weighting.

However, a research report from Morgan Stanley finds that the average weighting of the 10 largest components of the S&P 500 has averaged around 20% over the past 35 years. The current 30.45% weighting is even higher than the concentration seen in the S&P 500 during the dot-com bubble.

The Nasdaq 100, which is comprised of the 100 largest nonfinancial companies listed on the Nasdaq exchange, is even more concentrated than the S&P 500:

• Apple: 11.056%
• Microsoft: 9.529%
• Amazon: 5.39%
• Nvidia: 4.158%
• Meta Platforms: 3.77%
• Tesla: 3.145%
• Alphabet (Class A, GOOGL): 3.127%
• Alphabet (Class C, GOOG): 3.081%
• Broadcom: 2.969%

^NDX data by YCharts.

On an aggregate basis, these nine components account for 46.23% of the Nasdaq 100. The other 92 components -- Alphabet has two classes of shares, thus why there are 101 components and not 100 in the Nasdaq 100 -- account for less than 54% of the weighing of the index.

Historically speaking, when the major indexes become highly concentrated, things have "broken." To be clear, I'm not saying high concentration is why big downturns have previously occurred in the broader market. Rather, I'm pointing out that a high concentration in relatively few names has often left the major indexes susceptible to sizable downturns in the past.

Valuation and recession concerns are issues, too

If you're looking for reasons why a high concentration in the major stock indexes can lead to a breakdown in the broader market, look no further than recessionary concerns and the valuation of the Magnificent Seven companies.

For much of the past year, there has been no shortage of economic datapoints and predictive indicators pointing to a U.S. recession. This includes a decline in U.S. M2 money supply, meaningful tightening in commercial bank lending practices, a one-year contraction in the ISM Manufacturing New Orders Index, and a 17-month decline in The Conference Board Leading Economic Index.

A few of the Magnificent Seven stocks are cyclical and would struggle mightily if U.S. economic growth slowed or shifted into reverse. For example, Meta generates more than 98% of its revenue from advertising, with Alphabet in a similar boat. Advertisers are quick to pare back their spending at the first hint of economic weakness. Given the weighting Meta and Alphabet are responsible for in the S&P 500 and Nasdaq 100, they could be serious drags on these two indexes if/when the U.S. economy weakens.

There are also serious valuation concerns given the degree of uncertainty there is regarding economic growth in the coming quarters. For instance, Tesla is an auto stock trading at more than 70 times Wall Street's forecast earnings in 2023. Nvidia is commanding a higher price-to-cash-flow multiple than at pretty much any point in the past decade. Even Apple is going for a historically high 29 times forecast earnings this year despite the fact that its sales and profits are expected to decline by a low-single-digit percentage.

During periods of uncertainty, investors are less tolerant of outsized valuations -- even when they're attached to brand-name, time-tested, outperforming companies like Tesla, Nvidia, and Apple. In other words, the Magnificent Seven are in a precarious position, which, in turn, means the stock market may be, too.

Image source: Getty Images.

Patience is a virtue on Wall Street

Although the puzzle pieces would seem to suggest that choppy waters may be ahead for Wall Street, patience has proved to be an invaluable tool for long-term investors. Even if the Magnificent Seven stocks take the benchmark S&P 500 and Nasdaq 100 lower in the coming quarters, patient investors have a few things to look forward to.

For one, they'll be able to buy into or add to high-quality businesses at a perceived discount. Even though we'll never know ahead of time when stock market corrections will start, how long they'll last, or how steep the decline will be, we do know that every major decline in the major indexes has, eventually, been cleared away by a bull market. At minimum, it means index fund investors should use corrections as a surefire opportunity to pounce.

Long-term investors can also take solace in the fact that the proverbial sunny days handily outpace the rainy days on Wall Street.

According to an analysis from wealth management company Bespoke Investment Group, the average bear market since September 1929 has lasted 286 calendars days, or about 9.5 months. By comparison, the typical bull market over the past 94 years has lasted 1,011 calendar days, or roughly 3.5 times as long. Being a patient optimist strongly puts these figures in your favor.

No matter what the immediate future holds for stocks, long-term investors have every reason to smile.

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Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool's board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool's board of directors. Sean Williams has positions in Alphabet, Amazon.com, and Meta Platforms. The Motley Fool has positions in and recommends Alphabet, Amazon.com, Apple, Berkshire Hathaway, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool recommends Broadcom, Nasdaq, and UnitedHealth Group. The Motley Fool has a disclosure policy.