After Eights for Christmas

Our resident Grinch, multi-asset fund manager Will McIntosh-Whyte, brings us mixed tidings. Having been caught in a crowded trade for Christmas presents, he’s trying to avoid making the same mistake with the Magnificent Seven in our multi-asset portfolios .

By Will McIntosh-Whyte 19 December 2023 Will McIntosh-Whyte

This year I vowed to finally get organised. Go early, beat the crowds and do all my Christmas shopping in one smug morning. No longer would I be the typical bloke (if I am allowed to stereotype) rushing around Oxford Street the day before Christmas Eve, overpaying for gifts that in all likelihood will make their way back to the shop for a new year refund. 

Executing on this optimistic pledge, I booked a day’s holiday on the first Monday of December. Miss the Black Friday madness. Get ahead of the Christmas rush. Savvy. Sadly, I apparently wasn’t the only one with this genius idea. Two hours later I exited a hot and heaving department store, virtually empty handed, regretting the long lunch I’d had the day before as a pre-emptive celebration of my bulletproof shopping plan.

No such issue for central bankers this year. US Federal Reserve (Fed) Chair Jay Powell delivered his presents to markets early, gift-wrapped with a bow. Despite his statement not being dissimilar from last time, markets saw a chink in the ‘higher for longer’ armour, with the Fed saying they would need to start cutting rates “way before” inflation reached its 2% target, and that they were focused on the risk of keeping rates too high for too long. If you were wondering what the Fed ‘pivot’ that people were waiting for would look like, this felt like the very definition. 

A present, by yet another name

Cue presents all round. US Treasuries rallied, with the 10-year yield falling well below 4%. UK government bond (gilt) yields are closer to 3.7% (although subsequently Bank of England Governor Bailey has delivered coal to gilt investors). Equity markets flew. Interestingly, as I write, the notable laggards this week are the so-called Magnificent Seven (Apple, Google parent Alphabet, Amazon, Nvidia, Meta, Microsoft and Tesla). These giant companies astride the US stock market have high price-earnings multiples and strong growth rates that make their prices more sensitive to changes in prevailing bond yields. You would have expected them to lead a rally like this one, driven as it is by sharp falls in yields.

I despise these sorts of labels – like the FAANGS, BATFANGS and MAMAA (they generally reference the same US mega-cap tech stocks through more name changes than Prince). Putting aside my dislike for lazy groupings, you can’t dismiss the importance of these companies to American – and, in fact – global markets. The Magnificent Seven stocks make up 27% of the S&P 500. To put their size into context, the largest stock, Apple, is valued at over $3 trillion – more than the entire FTSE-All Share Index. Taking it a step further, the group of seven are a greater proportion of the FTSE All World Index than all UK, Chinese, Japanese and French stocks combined. So for global investors these stocks are arguably a much more important consideration than how much to allocate to our fair isles (and quite a number of other fair isles to boot!). 

Famously, every year David predicts that the US stock market will outperform its European counterpart. When we scored his predictions in our latest podcast, Europe had actually pipped the US – albeit the latest rally might have changed things – I am sure he will demand a recount! However, it wouldn’t even have been close if not for the seven largest US companies. Technology stocks have soared this year on the back of a very difficult 2022. And coupled with all the  excitement around AI (as well as  a little fear) they’ve driven the vast majority of the US index’s return. Thankfully, we own five of the seven (Meta and Tesla are the absentees), which has helped our performance this year. 

Don’t be a glutton

Although, given the sheer weight of these businesses in benchmarks, the question then becomes how much to own. A US equity fund might own all seven, but if even if you had less a full quarter of your fund in these names (which is a lot), you would still find yourself with significantly less exposure than the index. In our global multi-asset portfolios, we don’t have a relative benchmark, like a stock market index, but instead target specific outcomes (e.g. CPI +3% or the Bank of England Base Rate +2%). Our investment strategy is set by building portfolios of assets to seek optimal returns on the money we invest. We diversify our stocks both by name and sector weighting to avoid taking outsized risks in single stocks. In fact, we specifically have position size limits on individual stocks so that no one business can have a nasty impact on the portfolios. 

We like the five stocks we own in this group. But we’re wary that there are risks around them, regardless of their past performance. Regulation is always lurking, and punitive legislation from a new US administration – or a European or Chinese regulator – could knock these companies back. Fraud can happen, even to big companies – just ask owners of Enron. Cybersecurity remains a major ongoing threat, with sunglasses manufacturer Luxottica, telcos AT&T and T-Mobile and social media business Twitter (Now X) are just a handful of companies that have suffered material breaches this year. 

The valuations of many of these Magnificent Seven companies look a bit lively. Headline analysis tells you the group’s average price-earnings multiple has fallen (de-rated) this year. But that’s skewed by Nvidia, whose knock-out earnings increase led to a material de-rating and one of the largest single-day jumps in market-cap earlier this year – $184 billion). In English, its profits rose so much that the stock price couldn’t increase fast enough to keep pace. 

This is exactly the issue with grouping stocks together like this. With significant flows into these names, valuations may not be quite priced for perfection, but it feels like investors are looking to these businesses to be non-cyclical, and able to grow even in a downturn. We have for a while expected these businesses to be resilient in any kind of slowdown, but they won’t be immune to it. And any whiff of cyclicality in some of their earnings could trigger a reversal. While we like these stocks for the long term, we’ve been taking some profits into strength and recycling into other areas of the US including the Russell 2000, which is a home to much smaller US businesses, which to us look attractively valued on much lower multiples. 

The other stellar performer this year – now  one of the 10 largest stocks in the S&P 500 – is of course Eli Lilly, purveyor of panacea weight loss drugs (which we don’t own). So why not throw that stock in the mix with the Magnificent Seven? I can then coin another ridiculous nickname for the multitudes of overlooked companies beneath these investor darlings: the After Eights. My present to you. Just don’t eat too many over the festive period or you might be adding to Eli’s profits next year! Merry Christmas.

 

Tune in to The Sharpe End — a multi-asset investing podcast from Rathbones. You can listen here or wherever you get your podcasts. New episodes monthly.