The Magnificent 7 dominated 2023. Will the rest of the stock market soar in 2024?

That's the result of "extreme speculation," according to Richard Bernstein, CEO and chief investment officer of the eponymous firm Richard Bernstein Advisors. And it lays the foundation for investors to take advantage of “once-in-a-generation” investment opportunities, he argued in a phone interview with MarketWatch.

MarketWatch's Philip van Doorn noted last week that, weighing the Magnificent Seven: Apple Inc.
AAPL,
-0.55%

Microsoft Corp.
MSFT,
+0.28%,
Amazon.com Inc.
AMZN,
-0.27%,
Nvidia Corp.
NVDA,
-0.33%,
Alphabet Inc.
GOOD,
+0.65%

GOOGLE,
+0.76%,
Tesla Inc.
TSLA,
-0.77%,
and Meta Platforms Inc.
GOAL,
-0.20%

— by their market capitalizations at the end of last year, the group had contributed 58% of this year's approximately 26% total return for the S&P 500, down from the impressive 67% at the end of November.

The chart below shows that the percentage of S&P 500 stocks that have outperformed the index so far this year remains well below the average of 49% dating back to 1990:

Meanwhile, the tech-heavy Nasdaq Composite
COMP
has soared more than 40% this year, while the more cyclically weighted Dow Jones Industrial Average
DJIA,
which hit a series of records this month, is up 12.8%.

The narrowness of the rally made some technical analysts reflect throughout the year. They cautioned that this was uncharacteristic of early bull markets, which typically see broader leadership amid growing confidence in the economic outlook.

Bernstein, a former chief investment strategist at Merrill Lynch, sees parallels with the tech bubble of the late 1990s, which now offers lessons for investors.

Market performance indicates that investors have become convinced that there are only “seven growth stories,” he said. It is the type of myopia characteristic of bubbles.

The consequences can be dire. In the 1990s, investors focused on the Internet's potential to change the economy. And while those technological advances really changed the economy, an investor who bought the tech-heavy Nasdaq at the peak of the bubble had to wait 14 years to break even, Bernstein noted.

Today, investors are focused on the potential of artificial intelligence to change the economy, while overlooking other important developments, including the reshoring of supply chains.

"I don't think anyone is arguing that AI won't be an economy-changing technology," he said, "the question is what is the investment opportunity?"

For his part, Bernstein maintains that small cap stocks; cyclical, or stocks more sensitive to the economic cycle; industrial actions; and non-U.S. stocks are among the assets poised to catch up.

"I don't think you have to be too sexy here... it may not make a huge difference in how you decide to execute and invest" in those areas, he said. "There are billions of different ways to play this."

These areas are showing signs of life in December. The Russell 2000
RUT,
small-cap benchmark, is up more than 12% in December versus a 4.1% gain for the S&P 500. The Russell is still lagging by a wide margin so far this year, up 15%. .5%, or more than 8 percentage points behind the S&P. 500.

Meanwhile, an equal-weighted version of the S&P 500
XX:SP500EW,
which incorporates the performance of each member stock equally rather than giving greater weight to the most valuable companies, has also caught up, rising 6.2% in December. It is now up 11% in 2023, still trailing the cap-weighted S&P 500 by more than 8 percentage points.

Bernstein sees early signs of expansion, but hopes it will be an “iterative process.” What investors should aim for, he said, is “maximum diversification,” in direct contrast to the historically tight 2023 market, which reflects investors rejecting the benefits of diversification and taking more concentrated positions in fewer stocks.

To be sure, while the Magnificent Seven-dominated stock market rally has attracted plenty of attention, that doesn't mean those individual stocks have been the only winners in 2023.

"I will say 'magnificent' is in the eye of the beholder," Kevin Gordon, senior investment strategist at Charles Schwab, said in a telephone interview.

The seven stocks that account for such a large proportion of the S&P 500's gains do so primarily because of their extremely "mega" market caps rather than outsized price gains. And that is, by definition, how market-cap-weighted indices work, analysts say.

That doesn't mean mega-cap stocks will necessarily be the best performers in 2023. While Nvidia, up 243%, and Meta, up 194%, top the list of price gainers as far as this year in the S&P 500, Apple Inc.
AAPL,
-0.55%

it's just the 59th best-performing stock, with a gain of 49%. However, when you combine that with a market capitalization of $3 trillion, Apple turns out to be one of the biggest drivers of the overall index.

The strange thing about the 2023 rally wasn't so much the tech performance of the megacaps, Gordon said, but the fact that the rest of the market languished to such an extent until recently.

Clarity around the economic outlook and interest rates helps clear the way for the rest of the market to catch up, he said. Fears of a hard economic landing have faded, while the Federal Reserve has signaled it is likely finished raising rates and is on track to deliver rate cuts in 2024.

For stock pickers who didn't hold on to the few winners, 2023 was brutal. Passive investors who just bought ETFs that track the S&P 500 should feel good.

So why not just follow the index? Bernstein argues that could spell trouble if mega-cap names fail. This could be a mirror image of this year, where gains in a broader range of individual stocks are offset by sluggish performance in mega-caps.

Gordon, however, downplayed the prospect of “binary outcomes” in which investors sell mega-caps and buy the rest of the market.

If troubled segments of the economy, such as real estate, recover in 2024, investors “could definitely see a scenario where the rest of the market catches up, but it doesn't have to be at the expense of high-performers.” level,” he said.