Is the Mag 7 overvalued?

Key Concepts

Earnings Season: The period when publicly traded companies release their quarterly financial results.
MAG 7 (Magnificent 7): A group of seven large-cap technology companies (Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta, and Tesla) that have significantly driven market performance.
Margin of Safety: An investment principle, popularized by Warren Buffett, emphasizing buying assets at a price significantly below their intrinsic value to protect against unforeseen risks.
Margin Compression: A decrease in a company's profit margins, often due to rising costs or increased competition.
AI (Artificial Intelligence): The development of computer systems that can perform tasks typically requiring human intelligence.
PEG Ratio (Price/Earnings to Growth Ratio): A valuation metric that compares a company's P/E ratio to its expected earnings growth rate.
Free Cash Flow (FCF): The cash a company generates after accounting for capital expenditures.
Capex (Capital Expenditures): Funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, and equipment.
Idiosyncratic: Unique to a particular individual or thing; not general.
GARP (Growth at a Reasonable Price): An investment strategy that seeks companies with strong growth potential but are not overvalued.

Earnings Season Performance and Market Outlook

Current Earnings Season Observations

Broad-Based Strength: Thomas notes that earnings for companies outside the "MAG 7" are performing well, with 8-12% earnings growth reported so far, exceeding the expected 8%. Approximately 15-20% of the S&P 500 has reported.
MAG 7 Concerns: A significant focus is on the upcoming MAG 7 earnings reports. Thomas highlights that these companies are trading at 30 times earnings, with earnings growth falling from 32% to 14%. He argues there is "no margin of safety" with these valuations.
Margin Compression Theme: Early reports from Netflix and Tesla have indicated margin compression, even though they are not the largest AI spenders. This trend is expected to be more pronounced with the upcoming MAG 7 earnings.
Cash Position: Thomas's firm has raised some cash and plans to maintain it through the MAG 7 earnings reports due to anticipated spending and margin contraction.

Market Risks and Potential Corrections

Secondary Correction Risk: Brian points out that in years with market corrections exceeding 15% (like the nearly 20% correction in April), a secondary correction often follows, especially after hitting all-time highs. The average secondary correction is 3-9%, with a mean of 6.4%.
Interim Volatility: Brian anticipates more "chop and volatility" in the coming weeks before a potential year-end rally.
Unresolved Catalysts: Several geopolitical and economic concerns remain unaddressed, including a potential government shutdown, no deal with China, and open geopolitical questions.
Margin Contraction vs. High Multiples: The market faces a contradiction of consistent margin contraction alongside record-high multiples.
Positive Outlook for Next Year: The good news is that earnings are projected to grow significantly (double digits) next year. However, Brian warns that current spending is weighing on companies. Meta's layoffs in its AI department are cited as an example, questioning where growth is expected to come from.

Sector Performance and Credit Concerns

Financial Sector Strength

Banks Leading the Way: Scott notes that bank earnings have set a strong tone for the earnings season, with results generally looking solid.
Muted Price Action: Despite solid bank earnings, price action has been somewhat muted due to emerging concerns regarding credit.
Broadening Sector Coverage: As earnings season progresses, coverage will broaden across other sectors, with a persistent theme of earnings growth expected.

Credit Concerns: Idiosyncratic vs. Systemic Risk

"Flare-ups" vs. Fundamental Risk: Scott views current credit concerns as "idiosyncratic" (one-off) rather than a fundamental risk to the broader market.
Comparison to Past Crises: He acknowledges that investors are looking for signs of a "canary in the coal mine" similar to the tech bubble or global financial crisis.
Bank Conviction: The results from the banks provide "pretty good conviction" that underlying credit conditions are generally in good shape.
Accumulation of One-Offs: While individual one-off events are not concerning, the possibility of them accumulating needs careful monitoring.

The AI Bubble Debate

AI as a Market Driver and Bubble Concerns

Ubiquitous Discussion: The debate around an AI bubble is a constant in market conversations, driven by the significant performance of mega-cap tech and AI-related stocks over the past 1-3 years.
Bubble Burst Trigger: Scott emphasizes that bubbles typically burst due to an "inflection to the negative in fundamentals."
Positive Fundamental Trajectory: Current projections for underlying earnings growth drivers are positive through at least 2026-2027. As long as this continues, the AI bubble remains topical but not a significant market issue.
Shorter-Term Volatility: Expectations can sometimes get ahead of themselves, leading to shorter-term volatility even with good fundamental delivery.
"Early Innings" for AI: The AI playbook, including infrastructure build-out and corporate efficiency gains, is considered to be in its "early innings."

GARP Overlay on AI and Valuation

Growth at a Reasonable Price (GARP): Scott's team applies a GARP overlay to AI investments, looking for companies with PEG ratios consistent with market averages.
MAG 7 PEG Ratio: The MAG 7, in aggregate, has a PEG ratio of approximately two times, similar to the other 493 S&P 500 companies. This suggests the market is efficiently pricing in current growth expectations for these established companies.
Early-Stage Companies: Companies very early in their lifecycle without established earnings are treated differently.
Established Companies: Tried-and-true companies generating positive earnings and free cash flow contributing to AI infrastructure are generally in good shape valuation-wise.

MAG 7 Valuation and Financial Health

Free Cash Flow as a Key Metric

Free Cash Flow Junkie: Scott prioritizes free cash flow trends and growth drivers.
Astounding Free Cash Flow Generation: The MAG 7 companies are generating "astounding" free cash flow, a phenomenon not seen in his 40+ years of experience, differentiating it from the tech bubble.
Healthy Spending Habits: These companies are spending on capex but not in excess of their free cash flow generation. They are not heavily leveraging or issuing excessive stock, unlike in the late 1990s.
Financial Health: The financial health of these companies is "very, very compelling," enabling them to sustain spending and growth as long as free cash flow trends persist.

MAG 7 Quality and AI Investment Sustainability

Different Quality Profile: The MAG 7 companies possess a "very different quality profile" compared to past speculative bubbles. They consistently earn above their cost of capital.
AI Compute Infrastructure Buildout: The primary driver of MAG 7 momentum has been the AI compute infrastructure buildout.
Sustainability Question: The sustainability of this AI-driven momentum is a key question.
Capex Increases: Estimates for 2026 capex for the four largest hyperscalers have risen by over 40%, representing an additional $100 billion on top of the initial $300 billion projection.
Return on Investment: The ultimate return on this significant investment is yet to be determined.

Investment Strategy for MAG 7 and AI

Diversification Recommended: For new investments, diversification within the AI space is recommended.
Hold for Existing Investors: For investors who already hold MAG 7 stocks, a "hold" strategy is advised due to their profitability, upward earnings revisions, and the potential for AI to be a significant productivity enhancer.
Avoid Concentrated Bets: While holding is recommended, continuing to "press and concentrate" in the space is not advised.

Conclusion

The current earnings season shows resilience outside the MAG 7, but the focus is shifting to the high valuations and potential margin pressures within these tech giants. While credit concerns are present, they are largely viewed as idiosyncratic. The AI narrative continues to drive market interest, but investors are cautioned about the sustainability of AI-driven growth and the need for a "Growth at a Reasonable Price" approach. The strong free cash flow generation of MAG 7 companies is a key differentiator from past bubbles, suggesting a more robust financial foundation. For existing investors, holding these positions is recommended, but diversification is advised for new capital allocation in the AI sector.