Stocks Are Poised to Lead Tech Beyond the 'Magnificent 7’

Last year, concerns among stock investors revolved around the fear that technology companies with a disruptive impact would underperform, given the backdrop of higher interest rates and a weaker macroeconomic environment. This uncertainty, however, created a distinctive entry point for investors into various segments of the innovative tech ecosystem, particularly in software and semiconductors.

The year 2023 witnessed a surge in excitement surrounding generative artificial intelligence (AI), dominating U.S. equity-market sentiment and wealth creation. The standout performers, dubbed the "Magnificent Seven" tech stocks—Apple, Microsoft, Alphabet, Amazon.com, Nvidia, Meta Platforms, and Tesla—experienced substantial share-price gains, driving a remarkable 70% of the absolute performance of the Nasdaq Composite Index. These gains were not only extraordinary but justified, as the earnings per share for these companies rose by at least 50%.

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Contrastingly, smaller tech stocks faced challenges, with the MSCI ACWI Global Small Cap Tech index showing a 5% decline over the past two years. This decline was attributed to a weaker spending backdrop and pressure on multiples resulting from higher interest rates. The tech sector's growth trajectory lagged behind its normalized path, with worldwide information-technology (IT) spending growing below its long-term averages at 2.9% in 2022 and 3.5% in 2023.

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Multiples for smaller tech stocks were further impacted as the 10-year U.S. Treasury bond rate increased from 1.6% at the beginning of 2022 to 3.9% by the end of 2023. However, as 2024 unfolds, the growth rate for worldwide IT spending is anticipated to more than double. As the Federal Reserve approaches the end of its rate-hiking cycle, the pressure on multiples is expected to ease, signaling a potential shift in market leadership.

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In this evolving landscape, investors are advised to broaden their focus beyond the Magnificent Seven. Particularly attractive valuations are found in the software sector, where the difference between the fastest- and slowest-growing companies remains narrow. This presents excellent opportunities for investors to engage with the most disruptive segments of the market at reasonable prices.

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Pipelines are developing across industries and applications, encompassing next-generation data storage, cybersecurity, and software-development tools. Fueled by an improving spending environment and a more favorable rate backdrop, the beneficiaries of AI are likely to extend beyond the Magnificent Seven. Innovation is progressing rapidly, with companies introducing new solutions, products, and applications poised to accelerate growth.

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For investors seeking exposure to AI opportunities, three key areas are highlighted:

1. Enablers of AI: Cloud providers and semiconductor manufacturers stand to benefit significantly from the growing demand and investment in cloud vendors and AI data center development.
2. Data and security: Software companies focusing on refining and securing vast amounts of data for AI models are expected to experience heightened demand as digitization increases.
3. Applications: Enterprises across various sectors leveraging AI are likely to drive demand for innovative software and services as AI products become more specialized and domain-specific.

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Various investment opportunities arise for companies positioned to participate in a tech leadership change. Stocks like AMD, Micron Technology, MercadoLibre, and HubSpot are highlighted as potential beneficiaries of these growth trends in 2024 by Goldman Sachs Asset Management. It's crucial for investors to consider dedicated allocations to tech, given the industry's accelerating disruption and the potential for wealth creation opportunities.

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