Does the S&P 500 Have a "Magnificent Seven" Problem? Here's What Investors Need to Know.

Key Points

• The "Magnificent Seven" stocks that have led the market higher now sport enormous market caps.
• The S&P 500 is market-cap weighted, so its performance is heavily influenced by a small number of giant companies, most of which are now highly dependent on demand for AI solutions.
• If demand for AI doesn’t materialize or remain as sustained as hoped, many of these massive and interconnected technology companies could disappoint investors, creating a ripple effect.
• 10 stocks we like better than Microsoft ›

The past four years have been fantastic for the stock market. The S&P 500 (SNPINDEX: ^GSPC) has more than doubled in value from the bear-market bottom it sank to in September 2022, in fact, making this one of the faster-moving bull markets in recent history.

It's no secret why, either. The advent of artificial intelligence (AI) has been a boon for a handful of major technology companies, catapulting their stocks higher. Indeed, AI-driven bullishness is what made the "Magnificent Seven" -- Apple (NASDAQ: AAPL), Amazon (NASDAQ: AMZN), Alphabet (NASDAQ: GOOG)(NASDAQ: GOOGL), Meta Platforms (NASDAQ: META), Microsoft (NASDAQ: MSFT), Nvidia (NASDAQ: NVDA), and Tesla (NASDAQ: TSLA) -- so magnificent. With the exception of Tesla, these big tech names were best-positioned to capitalize on the AI revolution that reached critical mass in 2022. (Tesla's performance stemmed from the fact that the mainstream adoption of electric vehicles also reached a tipping point around that time.)

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As the old adage goes, though, nothing lasts forever. With the dust finally starting to settle, investors can now see just how much of the entire market's weight these seven stocks have been carrying. Many investors profited from their rise, but now, weakness from them could drag the market's performance down more than you might expect.

Here's what you need to know.

Alarmingly overweighted, somewhat overvalued

For the record, there have always been some companies with outsized influence on the S&P 500 -- and that's OK. It's a market-cap-weighted index, which makes it a pretty accurate representation of the stock market's collective behavior.

The heroic performances of a small number of stocks over the course of the past four years, however, have skewed the index into a condition that's dangerously unbalanced. For perspective, because the average Magnificent Seven company has roughly quadrupled in value since 2022's low, while the typical non-Magnificent Seven S&P 500 name has only gained a little over 80%, data from Yardeni Research indicates those seven megacaps -- 1.4% of the 500 companies in the index -- now collectively make up 31% of the S&P 500's total value.

Granted, things aren't quite as unbalanced as a comparison of just those two numbers implies. These same seven companies are also collectively producing a massive share of the S&P 500's total earnings.

There's still a problem, though. Despite making up 31% of the S&P 500's market cap, as Yardeni notes, the Magnificent Seven's total expected earnings for the next four quarters are just under 26% of the index's total expected earnings. That's why the Magnificent Seven's average forward price/earnings ratio is still uncomfortably high at 23.0, while the average forward P/E for every other S&P 500 stock is a far more palatable 17.3.

And while higher-growth stocks deserve the higher valuations they usually command, the valuation gap between these giants and the rest of the pack is particularly wide right now.

The potential problem

Investors haven't flinched yet, although they are starting to take note of these markedly different valuation numbers.

Perhaps the real risk here isn't so much the premium valuations of most Magnificent Seven companies, but rather, investors' growing recognition of how tenuous their underlying earnings projections are.

While Goldman Sachs believes the artificial intelligence industry is on pace to invest more than $1 trillion in AI infrastructure, hardware, and related services this year, at least as much next year, and again in 2028, the bulk of these companies' planned capital expenditures will be to other AI-centered megacap companies, several of which are also major stakeholders in the very same companies they're buying products and services from, and/or selling products and services to.

Microsoft not only provides ChatGPT owner OpenAI with cloud-accessible AI servers, for instance, but it also owns a sizable stake in OpenAI -- even as its own AI chat-based assistant Copilot (built on OpenAI's large language models) competes with ChatGPT. Meanwhile, OpenAI is not only buying AI server access from Coreweave, but simultaneously owns a piece of that cloud computing service provider, which also serves Microsoft, which buys hardware from Nvidia, which also sells hardware to OpenAI, which it also owns an equity stake in.

Meanwhile, Alphabet is a partial owner of AI platform Claude's developer Anthropic, which uses Google's machine-learning tech to support the ongoing development of its artificial intelligence models. Yet Anthropic also purchases compute capacity from Microsoft, which also holds -- along with Nvidia -- an equity stake in Claude's developer.

You get the idea. And that's just a small sampling of the tech industry's interdependence. Just know this: The bold predictions for most of the Magnificent Seven's future earnings growth are based on their assumptions about each other's success on the artificial intelligence front. If one falls short, it will have a measurable direct impact on at least one other industry player, and indirectly have an adverse impact on several others.

Too soon to panic, but not a worry to dismiss

Maybe it's not a problem at all. Perhaps these technology giants and their next-nearest cousins will produce the exact results expected of them. If so, as top-heavy as the S&P 500 may be, its overall valuation profile makes sense.

That's an awfully risky bet to make, though, knowing what we know, while also knowing that other enterprises are increasingly realizing that AI isn't quite living up to the hype and producing the returns on investment that were initially forecast. AI's useful to be sure, but it's not a panacea.

This slow, ongoing realization obviously works against the values of the Magnificent Seven stocks, and as a result, weighs on the whole S&P 500. Investors would be wise to keep this in mind, while also keeping their eyes peeled for any subtle clues that corporations outside of the technology sector are rethinking their AI plans.

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James Brumley has positions in Alphabet. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Goldman Sachs Group, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool has a disclosure policy.