In 2024, the Magnificent Seven contributed about 50 percent of the S&P 500 Index’s return and accounted for about 75 percent of earnings growth. However, this group of stocks — comprising Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla — may not sustain that level of dominance through 2025 and beyond. That’s a risk to investors without broadened equity market exposure.

“This whole Magnificent Seven theme — we’re all just waiting for it to die,” says John Bai, Senior Vice-president and Chief Investment Officer with NEI Investments, who points out that the U.S. market hasn’t seen this degree of concentration since the 1960s.

“It’s more concentrated than the dot-com bubble in 2000. It’s more concentrated than the Nifty Fifty back in the early 1970s. [And] when markets get this concentrated and they have these bubbles, they only do one thing: pop. And that’s never good for investors.”

Importantly, however, Bai doesn’t expect the aftermath of this period of overconcentration to look like the ones investors have experienced in the past.

“We’re not saying, like other bubble periods, that the bubbly part of the market is going to collapse and the rest of the market is going to outperform. We think [the Magnificent Seven] will continue to be steady, buoyed by their earnings growth rates. But the rest of the market is just going to catch up — and, when you have the highest-weighted stocks going sideways and the rest of the S&P 500 going up, it’s actually a pretty positive environment,” he says.

After all, the Magnificent Seven’s returns are justified to some extent by their strong earnings growth. The difficulty is that they are also expensive, trading at a 50 percent premium compared to the other 493 stocks in the S&P 500. Plus, the rate of change between Magnificent Seven earnings growth rates and the rest of the market’s is starting to narrow.

For example, Bai points out, quarter-over-quarter earnings growth rates in the fourth quarter of 2023 were 60 percent for the Magnificent Seven and negative for the rest of the index. On the other hand, projections for the first quarter of 2025 are for quarter-over-quarter earnings growth rates of less than 20 percent for the Magnificent Seven and more than 10 percent for the rest of the index.

Opportunity to buy cheaper stocks with solid growth potential

Clearly, 20 percent is still a healthy earnings growth rate, but there is an opportunity for investors to capitalize on a broader range of stocks’ 10 percent earnings growth rate at far lower valuations. Sectors that are well positioned for positive earnings momentum at reasonable prices include financials, healthcare, and energy, says Bai. He adds that cuts to interest rates by the U.S. Federal Reserve — which happened three times in 2024 — tend to result in outperformance by the equal-weighted index compared to the market cap-weighted index.

Bai anticipates that broad U.S. market performance will be supported by the new Trump administration’s pro-business policy tilt. An already strong U.S. economy is likely to benefit from tax cuts and deregulation — though tariffs, if imposed to the extent initially promised, will put upward pressure on inflation. There is also the potential for Trump’s policies to worsen deficits, increasing U.S. federal debt and keeping interest rates high. And, a combination of high inflation and high interest rates may push the U.S. into recession.

Still, Bai has a positive outlook for the broad U.S. equity market. “It’s a great environment for earnings [and] for investor optimism, so we think that provides a good backdrop.”

Time for active management to shine

“With the markets broadening now, we think investors will be well served by active management,” Bai emphasizes, pointing to the NEI Select RS Portfolios as simple, all-in-one active management solutions. “When markets are very concentrated in a few high market-cap securities, it’s very hard to beat the index. But when the economy starts to broaden, when earnings start to broaden, when the stock market starts to broaden, that’s when you see active management really shining.”

Whatever the economic and market environment, Bai says NEI Investments makes sure its portfolios don’t drift toward accidental overconcentration by taking an “X-ray” view of every fund to identify “unintended tilts.” In any mix of funds, there may be an unintentional overweight or underweight toward or away from a geographic region, capitalization size, or management style, for example. The key word there is unintentional. Those tilts are corrected so they don’t distort the intentional positioning of a portfolio.

Bai describes his team’s asset allocation approach as “re-optimization” rather than rebalancing. The process involves revisiting capital market assumptions on a regular basis to ensure portfolio allocations are optimized for long-term returns, expected earnings growth, valuation rates, and a multitude of other metrics that feed into capital market assumptions and portfolio construction. The long-term focus is important because it aligns with many investors’ time horizons, with the goal of capitalizing on areas with the highest probability of delivering the returns those investors need to accomplish their goals.

“We’re never going to be at neutral. We’re always going to have an active view on which factors we want to overweight or underweight, [but] we want to make sure the bets we’re making are intentional and aren’t too extreme,” says Bai.

About this article

This article was originally published on advisor.ca on January **, 2025.