Unusual Stock Market Phenomenon Raises Concerns

Something unusual is happening in the U.S. stock market, raising concerns among Wall Street economists. The S&P 500 index's recent surge has been largely driven by a select group of seven megacap technology stocks, often referred to as the "Magnificent Seven."

The Magnificent Seven includes Apple Inc., Microsoft Corp., Google owner Alphabet Inc., Tesla Inc., Amazon.com Inc., Facebook owner Meta Platforms Inc., and chipmaker Nvidia Corp. These stocks have now reached a staggering 29.6% of the S&P 500's total market capitalization, surpassing previous highs.

However, Torsten Slok, the chief economist at Apollo Global Management, warns that the valuations of these top stocks have become significantly disconnected from Treasury debt yields. Unless there is a significant decline in yields, Slok believes a substantial correction is inevitable.

According to data from FactSet, the forward price-to-earnings ratio for the top seven stocks has risen from 29 to nearly 45 since the beginning of the year. This metric is commonly used to evaluate how companies are valued relative to their expected profits.

What makes this situation even more surprising is that valuations have continued to soar despite the increase in yields. Traditionally, changes in bond yields and interest rates have had a significant impact on technology stocks and other growth names. Higher interest rates are generally considered to reduce the value of future profits to investors. However, this time seems to defy this common belief.

While the stock market's reliance on a handful of tech giants has propelled its gains, economists like Slok caution that such concentration poses inherent risks. As investors closely monitor these developments, many wonder if this unprecedented phenomenon will eventually lead to a course correction in the market.

The Theory Behind Megacap Technology Stocks

At least, that's the theory.

Insulated from Higher Interest Rates?

Amidst the highest levels of yields since the 2008 financial crisis, megacap technology stocks have performed remarkably well. Some equity market analysts suggest that their success can be attributed to their large cash balances and minimal corporate debt. This insulation from higher interest rates has allowed them to thrive even in turbulent times, often diverging from the rest of the market.

Closing the Divergence

However, there are concerns that this divergence between technology stocks and Treasury yields may not last much longer. As interest rates continue to rise, the market's dependence on these tech giants could be at risk. Torsten Slok, a prominent analyst, believes that either stock prices need to align with current interest rates or interest rates must adjust to match stock prices.

"In short, something has to give. Either stocks have to go down to be consistent with the current level of interest rates. Or long-term interest rates have to go down to be consistent with the current level of stock prices," Slok explained.

The Weight of Tech

Slok's viewpoint is supported by a chart demonstrating the heavy influence of tech stocks on the Nasdaq 100 index. As one of the most tech-focused indexes in the United States, the Nasdaq 100 is significantly weighted towards these top-performing stocks.

Slok is not alone in his prediction. Thomas Peterffy, Founder and Chairman of Interactive Brokers Group Inc., also expressed his belief that these megacap technology stocks could soon experience a decline.

Fresh Multi-Year Highs for Treasury Yields

On Wednesday, Treasury yields reached fresh multi-year highs. The 2-year note hit its highest level since 2006, while the 10-year note and 30-year bond reached their highest levels since 2007. This upward trajectory in interest rates raises concerns about the sustainability of tech stocks' current performance.