Magnificent Seven’s slowing growth threatens S&P 500 rally

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Last week, DeepSeek’s emergence as an AI threat wiped half a trillion dollars of value off Nvidia Corp. Last night, Alphabet Inc.’s disappointing earnings sparked questions about its capital expenditures and put its stock on pace for the worst drop in more than a year.

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The jolts reflect a deeper concern about a key narrative that has underpinned much of Big Tech’s rally for more than two years, and thereby the U.S. market’s strength: is all the AI spending going to pay off?

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The so-called Magnificent Seven have driven the S&P 500’s earnings expansion and equity returns, with the group comprising about one-third of the benchmark’s weight. They’ve made up more than half of the index’s gains over the past two years, but their profit growth is decelerating just as their spending rises.

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The concerns raise a threat to their lofty valuations, given the group trades at a 40 per cent premium to the broader S&P 500 based on forward price-to-earnings ratios. That spread has already been ebbing, falling from a peak of 70 per cent back in 2023.

Year-over-year earnings growth for the biggest companies peaked in late 2023 and is expected to slow for a fifth consecutive quarter, according to data compiled by Bloomberg Intelligence. Five of the seven firms have reported results so far in this period, while Amazon is due on Thursday and Nvidia is expected later in the month.

“The contrast between the CapEx and cash flow growth of the Magnificent seven and the rest of the S&P 500 is quite remarkable,” wrote Andrew Lapthorne, Global Head of Quantitative Research at Societe Generale SA.

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The largest seven companies grew capital spending by 40 per cent year-on-year in 2024, compared to growth of just 3.5 per cent for the rest of the S&P 500, according to Lapthorne.

Alphabet’s cloud unit, considered one of the clearest indicators of the AI boom, missed expectations in the fourth quarter. The company expects US$75 billion in 2025 capital expenditures, far exceeding the US$57.9 billion that analysts expected.

Trade tensions, geopolitical concerns and the sudden emergence of DeepSeek last week add to the pressure for the group. Meanwhile, investors will look for signs of stronger profit growth among the rest of the US benchmark.

Year-over-year earnings growth is declining “dramatically” for Magnificent Seven stocks while the trajectory improves for rest of the S&P 500, said Kristian Heugh, manager of Morgan Stanley’s Global Opportunity Fund.

While exposure to the Magnificent Seven group was important for fund managers trying to keep pace with benchmarks in recent years, it won’t necessarily be the case going forward.

“While they are clearly at a high market cap, that may not be where the alpha is getting generated,” Heugh said.

With assistance from Henry Ren, Jeran Wittenstein and Subrat Patnaik

Bloomberg.com

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