In the three-year bull market, the S&P 500 index has largely moved in tandem with the stock prices of major technology companies. However, this strong correlation is now abruptly breaking down—a development that may bode well for the underperforming tech sector. The correlation between an index tracking the "Magnificent Seven" and the S&P 500 Equal Weight Index—which offers a clearer picture of overall market performance by reducing the influence of the largest companies—turned negative on February 23, indicating that the two are no longer moving in sync. Since then, amid market disruptions caused by the Iran conflict and a surge in oil prices, this negative correlation has deepened.
One industry expert noted the unprecedented speed of the current technology cycle, making future developments particularly difficult to forecast. Since early 2016, such a pronounced negative correlation has only occurred once before. In the first quarter of 2023, following the launch of ChatGPT by OpenAI in late November 2022, the "Magnificent Seven"—comprising NVIDIA, Apple, Microsoft, Alphabet, Amazon.com, Meta Platforms, Inc., and Tesla Motors—led the market higher. Meanwhile, the rest of the S&P 500 struggled to emerge from a bearish phase. From January to March 2023, the Magnificent Seven index surged 45%, while the standard S&P 500 rose only 7%. Eventually, enthusiasm for technology spread across the broader market, lifting the S&P 500 by 24% for all of 2023 and an additional 23% in 2024.
The recent breakdown in correlation comes after months of underperformance by the Magnificent Seven, driven by concerns over massive artificial intelligence-related expenditures. From late October last year through February, the Bloomberg Magnificent Seven index fell 7.3%, while the S&P 500 Equal Weight Index, led by cyclical sectors like energy and materials, climbed 8.9%. In the weeks following the shift to negative correlation, the performance trends of the two indices reversed. Although the Magnificent Seven entered a correction this month, their decline has been smaller than that of the broader market benchmark.
Market conditions today differ significantly from those three years ago, with the Iran conflict casting a shadow. In addition, the Magnificent Seven face pre-existing concerns about heavy AI investment and the disruptive potential of the technology. A portfolio manager recalled that during a period of high correlation, NVIDIA consistently delivered upward earnings revisions, and there was less anxiety about capital expenditure, return on investment, AI, software, or supply chain issues like memory shortages affecting Apple.
The last time correlations were this negative marked the beginning of a significant period of outperformance for the Magnificent Seven. From early 2023 through February 23 of this year, the Magnificent Seven index soared more than 300%, while the S&P 500 Equal Weight Index rose only 42% and the standard S&P 500 advanced 78%. While few on Wall Street expect an exact repeat, there are reasons for optimism that the Magnificent Seven may regain market leadership. A chief equity strategist noted that the recent pullback has cleared out speculative excess and brought valuations to attractive levels, setting the stage for potential future outperformance. He pointed to extreme capital outflows from U.S. equities to international markets, a reversal triggered by tariff concerns last April, and suggested that the tech sector, particularly large-cap tech stocks, stands to benefit.
Market data show the Magnificent Seven index now trades at a forward price-to-earnings ratio below 25 times, down from nearly 33 times in October and below its 10-year average of 29 times. This is the lowest level since the "tariff scare" last April. Given that these seven companies account for roughly one-third of the S&P 500's market-cap-weighted index, a recovery in tech giants would be a significant positive for the overall market. One analyst suggested that large-cap tech stocks are becoming increasingly compelling, offering stability and a track record of exceeding expectations.
However, a major concern for bulls is NVIDIA. As the world's most valuable company and the largest weighting in the S&P 500, its upward momentum has stalled. After surging more than 1,100% from late 2022 through July of last year, the stock has traded sideways over the past seven months amid worries that its rapid growth is nearing a peak and that investors are growing weary of massive AI spending by its largest customers. These concerns were evident last week when the CEO's forecast of $1 trillion in data center sales by 2027 failed to lift investor sentiment. Despite other positive announcements, including resumed AI chip sales approval in China, the stock ended the week down 4.1%. One portfolio manager interpreted the market reaction as a sign that earnings expectations are too high, though he still finds the stock attractive.
Another challenge for the Magnificent Seven is deteriorating free cash flow due to heavy spending on AI computing infrastructure. The biggest spenders—Amazon.com, Microsoft, Alphabet, and Meta Platforms, Inc.—are projected to see combined free cash flow drop significantly to $94 billion this year, down from $205 billion expected for 2025 and $230 billion for 2024. A chief market strategist argued that despite lower valuations, concerns about data center spending and depreciating assets on balance sheets remain a major issue. He suggested that the shift in the business model of hyperscale companies justifies lower valuations, and the 30% valuation gap between the S&P 500 and its equal-weight counterpart makes the latter appealing for investors seeking to navigate volatility.
Nevertheless, earnings growth for the Magnificent Seven remains strong. Their profits are projected to increase 19% in 2026, compared with 14% for the other 493 companies in the S&P 500. This ability to generate above-market profit growth, one analyst emphasized, is ultimately what investors value most, making it difficult to look beyond these standout performers.
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