Two alternatives to the Magnificent Seven

There is one dominant question for financial markets in the year ahead: stick or twist on the US technology giants?

It is the same question that many investors were asking this time last year. In that case, the right answer was unequivocally to stick. The CNBC Magnificent Seven Index (which includes Apple, Alphabet, Amazon, Meta, Microsoft, Tesla and Nvidia) has risen 78% over the past year*.

This year, the question is more nuanced. For a start, anyone with an S&P 500 tracker will already have an awful lot in the Magnificent Seven. The top 10 constituents in the S&P 500 now make up over 37% of the overall index**. This is the highest concentration in the index’s history. It is a similar picture for anyone with a holding in the MSCI World, the Nasdaq or similar.

Also, some of these stocks are starting to look very expensive, and that should be a red flag for investors. While most of these businesses continue to deliver strong revenue and profit growth, no investment trend lasts forever and it is often high valuations - rather than a problem for the businesses themselves - that trigger a downturn.

While we wouldn’t recommend anyone ships out of the US market wholesale – it remains the largest, most liquid stock market in the world, and home to some astonishing companies – we would suggest balancing a weighting in the index heavyweights with some alternative options.

Please remember that the value of investments will fluctuate and returns may be less than the amount originally invested. Tax treatment depends on your individual circumstances and tax rules can change. Chelsea does not offer advice and so if you are unsure of anything please contact an expert adviser

Smaller companies

US smaller companies have been left behind in the general fervour for technology. However, there are signs of a revival in the wake of Donald Trump’s victory. His agenda of tax cuts, deregulation and ‘made in America’ should benefit US smaller companies, and the Russell 2000 index rallied in the immediate aftermath of the election.

The Premier Miton US Opportunities fund largely sidesteps the index heavyweights, preferring to focus on mid and small-cap companies. This gives the fund a far greater focus on the domestic US economy. Manager Hugh Grieves points out that the US economy is in good shape compared to the rest of the world - “a shining light of growth and health compared to other markets”, he says. The IMF is forecasting 2.2% GDP growth for the US, higher than any other major economy except Canada***.

Hugh is optimistic that growth can continue in the year ahead. He says: “Consumer confidence is ticking up and if consumers choose to take on more debt that’s going to be a big tailwind to the economy.” He also sees growth from a revival in the housing market and in manufacturing: “I think with the election out of the way there has been an element of pent-up demand. People were not wanting to commit to big projects ahead of the election not knowing what the tax situation was going to be. Well, now we have certainty.”

Smaller companies should also be beneficiaries of lower interest rates, should they materialise. The Federal Reserve is currently suggesting there will be two cuts in the course of 2025, shaving 0.5% off the Federal Funds rate****.

Income stocks

The other area that might be worth looking at for 2025 is US equity income. The US tends to be seen as a growth rather than an income market, but there are plenty of good industrial companies paying high and growing dividends. The S&P 500 Dividend Aristocrats index has significantly lagged the broader S&P 500 index in 2024, suggesting dividend stocks may be due to catch up in the year ahead.

The JPM Global Equity Income fund has 64% in US dividend-paying companies, including Microsoft, McDonald’s and healthcare groups Abbott and United Health^. The management team on the fund believe that dividend stocks could have a tailwind in 2025. Payout ratios – the amount a company pays out in dividends relative to its profits – are low relative to history, giving companies scope to increase their payouts in the year ahead. By targeting dividend-paying companies, investors also give themselves some protection against inflation, which remains a risk in the year ahead.

Dividend companies may also prove more defensive if the economy turns south in the year ahead. They are on lower valuations - like smaller companies, they have been widely overlooked and there is a significant gap in the valuations of dividend companies versus the rest of the market. They also tend to be focused on more defensive sectors such as healthcare and financials. Finally, the dividend itself provides some stability to a portfolio in choppy markets.

The US market has been a great home for investors’ capital over the past few years and there is no need to bid it farewell over worries on the valuations of the index heavyweights. However, many investors already have a lot of exposure to it, so it is worth balancing it out with exposure to other parts of the US market, including smaller companies and dividend stocks.

*Source: CNBC Magnificent 7 Index, at 6 January 2025
**Source: S&P index factsheet, 31 December 2024
***Source: IMF, World Economic Outlook, October 2024
****Source: FT, 19 December 2024
^Source: fund factsheet, 31 December 2024

Past performance is not a reliable guide to future returns. You may not get back the amount originally invested, and tax rules can change over time. The views expressed are those of the author and fund managers and do not constitute financial advice.