What The Real Magnificent Seven Can Teach Us About Investing
Whenever the stats are shared about what the inflation number is, it is quite common for people to deplore said inflation number, as to most that is not a true reflection of their own personal cost of living increase. I can relate to that, and for that reason I can empathise. The problem with a baseline, or average number like inflation is that it tends to be quite far from the numbers that are scattered around it. These scattered numbers are what are unique to each person. By the same principle is the S&P 500’s performance a true reflection of the majority of the performance of individual portfolios? Given that it was decided that U.S investor performance is usually benchmarked against the S&P 500, I am willing to bet that very few investors’ portfolios are 100% the S&P 500 Index, whether it is the market cap weighted ETF like SPY, or the equally weighted ETF like RSP.
Reading Sam Ro’s substack last weekend, and coming across this reminder that “Most Pros Can’t Beat The Market”, one can only wonder how retail investors faired. 59.7% of the U.S. Large Cap Equity Funds Managers of the pros, measured up to June 2023, were underperforming the S&P 500. It should be difficult to outperform the Index, and the evidence is it is. The problem with stating that as “the benchmark”, creates the impression that it is a standard achieved by the majority of market professionals! So why don’t we have more people equally as vocal to protest how the S&P 500 Index is not a true reflection of how their portfolio is performing? The cynic in me has answers, but that is not the focus for today.
For those in the peanut gallery, it is tempting to judge the pros that made up the 59.7% funds that underperformed, but there are plausible reasons as to why the result makes sense. One of the things that can keep a portfolio manager up at night, is feeling like they have too much exposure to one stock, or sector, or theme. By nature of what people seek in optimising and diversifying a portfolio, it is an unlikely outcome that a portfolio manager would have 3 stocks making up 21% of their portfolio. If you sit with 3 stocks being more than 21% of your portfolio, you will be a hero when those three stocks do well, but your risk management will come into question should they do poorly, as their performance will drag or tank you and possibly your job.
Portfolio Managers not only have to safeguard their clients’ money, they also have to think about job preservation. Building a career managing money is very difficult if you choose to take unacceptable risks and lose your clients’ money. It is one thing for the S&P 500 - a market cap weighted index - to have 3 stocks in the index have a weight of circa 21.51% and they comprise Apple, Microsoft and Alphabet (Google parent company). However, it is quite another for a portfolio manager who is not replicating any index to allow for that level of concentration risk in their portfolio. Managing risk is a crucial part of managing portfolio performance.
Now let’s look at the actual market. Whereas in the last couple of years popular performing stocks were given an acronym like FANG or FAAMG, this year’s credit for the S&P 500’s performance is highly attributed to The Magnificent Seven! Many other companies in the S&P 500 were rising, but the Magnificent Seven took on a more noticed and talked about trajectory. Karen Langley’s Wall Street Journal article titled, Meta, Amazon Earnings Put Stock Market To The Test, flagged that while the S&P 500 was up 11% (on a total return basis), without the Magnificent Seven the total performance would have been a paltry 0.6% for the same period up to Friday 20th October 2023. Five hundred stocks in the Index more or less, and Seven stocks are doing all that heavy lifting? No wonder 59.7% of the funds were underperforming the S&P 500 up until June this year.
Karen’s article could not have been better timed. One of the Magnificent Seven, Tesla, had reported earnings in the week that she published her article. Tesla’s stock was already down 15% in the week and fell a further 2% in the week after she published. I had to laugh when on Monday, Joe Taranova was on CNBC and he quipped “we may as well stop calling them The Magnificent Seven and call them the Magnificent Six”! If you have watched the 1960 Western Film, starring Yul Brynner, Steve McQueen, Eli Wallach, Charles Bronson and other stars that were my childhood heroes, you may also be thinking that the Magnificent Six does not quite have the same ring to it.
Meta (Facebook parent company), Alphabet (Google parent company), Microsoft and Amazon reported earnings during the week after Karen’s article. So now that five of the Magnificent Seven have shown us their guns, we await Apple and NVIDIA to finish the set. Meta is down over 3% in this past week, Alphabet is down just short of 10%, Microsoft was up slightly, just under 1% and Amazon fared the best of the group having gone up 2% in the week. If you add that Apple and NVIDIA are yet to report, and they were down close on 2.70% and 2% respectively, it is not surprising that the S&P 500 was down 2.53% for the week.
Tesla’s earnings were terrible, so the reaction of the market makes sense. The rest though, are a stark reminder that in the short term, performance of stocks depends on the mood of market participants. If Mr Market is in a good mood, your returns will benefit, and vice versa, as Ben Graham put it in his teachings. Meta beat analysts expectations in terms of revenue and earnings, as did Microsoft, Alphabet and Amazon. Yet the market was in good spirits about Amazon’s future prospects and demanded more of the stock than was being supplied, hence the stock price going up. On the other hand though, Meta, Alphabet and Microsoft were sold off, as if getting rid of an unwanted burden. The impressive part is on a nominal basis, Meta is still up 146% so far this year, Tesla is still up 68%, Alphabet is still up 39% and Microsoft is still up 37%. These are not normal returns especially for such large companies in terms of market value. So of course expect some panic and concern about the overall performance of the S&P 500 should the collective Magnificent Seven start falling to the same degree as they have had a parabolic rise so far this year.
The price of stocks, as is the case for any asset price, is the outcome of a “tug of war” between market participants, where Buyers believe prices of those stocks they are buying will rise in future (demand) and Sellers who believe prices of those very stocks will fall in future (supply). So for whatever reason, this past week, and the past couple of weeks, there are more Sellers of the Magnificent Seven stocks as well as the broader balance of stocks in the market, than there are Buyers. Until the sentiment changes, the Magnificent Seven will continue to be outgunned.
What is interesting with the real Magnificent Seven, the 1960 Western film, is that they successfully helped the village of farmers (in fending off and defeating the bandits). However, only three of the Magnificent Seven survived. After the final battle, a village elder tells Chris, the leader of the Magnificent Seven, that only the villagers (the farmers) had really won. The elder compares the work that the Magnificent Seven did as similar to how a strong wind helps farmers get rid of locusts. “unlike the farmers who are like the land itself, winds blow over and pass on”. I don’t think the media thought that through when they dubbed these particular Mega Performance stocks as The Magnificent Seven. It certainly is not a good omen for the Magnificent Seven if these stocks and their performance is a strong blowing wind, and the rest of the stock market that is not getting the heroic recognition is the farmers. Then again, it is just an analogy referencing a movie released in October 1960.