Will Technology Stocks and AI Enthusiasm Continue to Propel Markets?

The best-performing sectors in 2023 were Technology (+57.8%) and Communications Services (+55.8%), the latter of which includes companies like Google, Meta, and Netflix. But the real story in 2023 was of the “Magnificent Seven” stocks, which drove a lion’s share of the stock market’s full-year returns based largely on enthusiasm for generative AI technology.

According to an analysis conducted by the Carlyle Group, there were roughly 40 AI-related stocks in the S&P 500 that all experienced strong returns in 2023. Without them, the S&P 500 would have risen about half of much as it did last year.¹

This begs the question: can this AI-driven enthusiasm continue, and is there more runway for technology stocks to bolster markets again in 2024?

The best way to address this question, in our view, is to focus on earnings. Let’s start with the Magnificent Seven stocks, which swallowed headlines last year. They are Apple, Google, Microsoft, Amazon.com, Meta Platforms, Tesla, and Nvidia. Many investors viewed the wild outperformance of these names as a sign of investor euphoria and/or the possibility of a bubble forming. But this characterization may be somewhat unfair—the Magnificent Seven arguably have the strongest balance sheets in the world, and they all generate envious levels of free cash flow, have above-average profit margins, and delivered earnings growth of 33% in 2023 compared to -5% for the rest of the S&P 500.

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In the fourth quarter of 2023, for instance, earnings for the Magnificent Seven are expected to be up +41.3% from the same period last year on +13% higher revenues, which would follow the group’s +54.2% higher earnings on +12.9% higher revenues in 2023 Q3. Simply put, these are outstanding earnings numbers.

The Magnificent 7: Quarterly Earnings and Revenue Growth Rate (YoY)

To be fair, investors may be paying too high of a premium for these strong earnings. But the Magnificent Seven are, at the very least, giving investors a lot of reasons to own them, particularly in the realm of elevated free cash flow and numerous competitive advantages. During the late 1990s technology stock swoon, many companies didn’t have proven business models or even any earnings at all.

Beyond the Magnificent Seven, the earnings outlook for technology stocks is also looking brighter. In early 2022, we saw many sectors, especially technology, downgrading earnings estimates and many engaged in layoffs to ‘get leaner’ following the post-pandemic hiring glut. For the Tech sector as a whole, as of February 1, we have Q4 2023 earnings results for 46.8% of the sector’s market capitalization in the S&P 500. Total earnings for these Tech companies are up +19.3% from the same period last year on +6.6% higher revenues, with 82.1% beating EPS estimates and 75% beating revenue estimates. The Q4 earnings and revenue growth rates for these Tech companies are notably tracking higher than what we have seen from these companies in other recent periods.

Again, all good signs.

Bottom Line for Investors

There is plenty of hype behind the promise of generative AI, and investors may be wary of ‘hitching your wagon’ to technology optimism. Many remember the late 1990s bubble bursting, and there have been recent technological innovations—like robotics, EVs, virtual reality, and 3-D printing—that have not panned out as many hoped.

But the good news here is on two fronts. First, technology companies are generating attractive earnings and free cash flow, and businesses are increasingly adopting AI tools in efforts to increase productivity. Earnings estimates reflect as much. Second, the outperformance of the Magnificent Seven last year has made the stock market look expensive—with a forward P/E of 19.5x—which we think masks some unique opportunities in the year ahead. If you look at the forward P/E multiple of the equal-weighted S&P 500—which gives equal weighting to the Magnificent Seven and all other 493 stocks—it is evident the stock market is not uniformly stretched from this vantage, the forward P/E falls to a more reasonable 16x.

Additionally, when we look beyond US mega-caps, earnings yields look reasonable relative to history, and in many areas, valuations have improved relative to last year. We view this as a wide opportunity set, particularly given our belief that positive operating leverage and productivity growth from artificial intelligence should lead to margin expansion across many industries in the coming years.

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¹ Wall Street Journal. January 4, 2024.

² Zacks Investment Management may amend or rescind the A Better Way Forward: Actively Managing Passive Index Funds guide offer for any reason and at Zacks Investment Management’s discretion.

³ Zacks. January 31, 2024.

⁴ Zacks Investment Management may amend or rescind the A Better Way Forward: Actively Managing Passive Index Funds guide offer for any reason and at Zacks Investment Management’s discretion.

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