7 stocks are holding up the U.S. market. Here is why they may soon fall back to earth.

By Joseph Adinolfi

Something unusual is happening in the U.S. stock market, and it's making one prominent Wall Street economist nervous.

At this point in the year, the notion that the S&P 500 index SPX 2023 advance has been powered by a handful of seven megacap technology stocks is hardly novel. Sometimes called the "Magnificent Seven," the group includes Apple Inc. (AAPL), Microsoft Corp. (MSFT), Google owner Alphabet Inc. (GOOGL) (GOOG), Tesla Inc. (TSLA), Amazon.com Inc. (AMZN), Facebook owner Meta Platforms Inc. (META) and chipmaker and artificial-intelligence darling Nvidia Corp (NVDA).

An equity strategist at Bank of America recently calculated that this group of megacap technology stocks now constitutes 29.6% of the S&P 500's total market capitalization, surpassing previous highs.

But according to Torsten Slok, chief economist at Apollo Global Management, valuations for the top seven stocks in the S&P 500 have become so out of whack compared with the level of Treasury debt yields that a powerful correction is nearly guaranteed, barring a substantial decline in yields.

According to FactSet data, the list of the seven largest stocks in the S&P 500 by market capitalization includes all of the Magnificent Seven names except Alphabet's Class C shares.

Since the start of the year, the top seven have seen their forward price-to-earnings ratio, a metric commonly used to describe how companies are being valued relative to their expected profits, swell from 29 to nearly 45, Slok said.

Perhaps more surprising is the fact that valuations have soared even as yields have marched higher. This would seem to defy a common truism about equity-market valuations.

In the past, technology stocks and other growth names have been extremely sensitive to changes in bond yields and interest rates. This is rooted in the notion that higher interest rates in the present make future profits less valuable to investors, since they can lock in higher returns with little risk now.

At least, that's the theory.

So, why have megacap technology stocks performed so well with yields at their highest levels since before the 2008 financial crisis? Some equity market analysts believe they have become insulated from higher interest rates thanks to large cash balances and low corporate debt.

Some say they act like safe havens for investors during times of market upheaval. This dynamic has occasionally played out this year on days where the Magnificent Seven have climbed while the rest of the market has fallen.

Whatever the reason, Slok expects the divergence between technology stocks and Treasury yields will soon close, potentially kicking away the last leg supporting the market.

"The conclusion is that tech valuations are very high and inconsistent with the significant rise in long-term interest rates, see the second chart," Slok said in emailed commentary.

"In short, something has to give. Either stocks have to go down to be consistent with the current level of interest rates. Or long-term interest rates have to go down to be consistent with the current level of stock prices."

Slok shared a chart showing how the Nasdaq 100 NDX, perhaps the most tech-heavy of the major U.S. indexes, is also the most heavily weighted toward the top stocks.

Slok is hardly alone in this view. During an interview on CNBC Wednesday, Interactive Brokers Group Inc. (IBKR) founder and chairman Thomas Peterffy said these megacap technology stocks could soon deflate.

Treasury yields marched to fresh multi-year highs on Wednesday, with the 2-year note BX:TMUBMUSD02Y hitting its highest level since 2006 and the 10-year note and 30-year bond hitting their highest levels since 2007.

-Joseph Adinolfi

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10-18-23 1005ET

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