Big Tech takes a back seat after the AI hype cycle
Smaller-cap stocks are primed to flourish in the wake of Magnificent Seven losses.
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Throwing the word "AI" around isn't what it used to be.
The biggest names in tech drove the stock market's surge this year, pivoting from the cold afterglow of cost-cutting layoffs to riding high on the exuberance of AI.
But the mega-cap stocks that led the way won't be what takes the S&P 500 higher on its next journey upward. It will be the other 493 companies with much lower valuations but higher potential to outperform, analysts say, without the baggage of inflated valuations or the pain from the tumble after the AI run-up.
Opportunities for value stocks, cyclicals, and beaten-down industries lie in the S&P's weighting.
The market caps of the Magnificent Seven stocks — Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Alphabet (GOOGL), Nvidia (NVDA), Tesla (TSLA), Meta (META) — account for 28% of the index, highlighting how top-heavy the index has become.
The S&P 500 is essentially a high school basketball team right now with a few 6-footers and a lot of 5-foot-3 kids. The stocks that haven't had a growth spurt yet are in a good position to contest for Most Improved Player.
As tech stocks slid, so did the index. The S&P in September suffered its worst performing month so far this year. But those losses could inspire smaller-cap stocks to flourish, as my colleague Josh Schafer reports, with gains spread in a more healthy distribution across the market, instead of in a concentrated few.
Still, even as analysts see smaller names eventually leading the charge on Wall Street, when that rotation will arrive is less clear. Unlike that basketball team, there are no guarantees of growth spurts and a stock can have more than one.
SoFi head of investment strategy Liz Young said she thinks the shift to smaller-cap stocks could be underway, but she doesn't see a next leg higher for the S&P 500 on the "imminent horizon." Valuations for Big Tech and the broader S&P still have further to fall, she believes, before a slowdown kicks off a new business cycle with a new roster of names posting the biggest gains.
Others don't predict a slowdown, but still see a viable path for smaller stocks to drive the market.
Bank of America's research team, for instance, bucked what had been a prevailing and protracted narrative of an impending contraction and removed its recession call in early August. The equity strategy team led by Savita Subramanian sees the S&P rising to 4,600 by the end of the of the year.
That's a 7% increase from where the benchmark index closed in September. But while analysts disagree over timing, there's the sense that the mega cap stocks will take a back seat.
The Bank of America team noted their "highest conviction call" remains that the equal-weighted S&P 500, which strips out the market cap weighting of stocks, will outperform the standard S&P 500 index and its heavy skew to the Magnificent Seven.
"We think cyclicals are the next leg where this market really could potentially reside," Bank of America equity & quant strategist Ohsung Kwon told Yahoo Finance. "Basically it's the complete opposite of what worked earlier this year."
Hamza Shaban is a reporter for Yahoo Finance covering markets and the economy. Follow Hamza on Twitter @hshaban.
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