By Lewis Krauskopf
NEW YORK (Reuters) -Hopes that the U.S. stocks rally will broaden beyond megacaps like Nvidia (NASDAQ:NVDA) will be tested in coming weeks as investors learn whether profit growth from other companies is starting to catch up with that of the tech-related leaders.
The S&P 500 has rallied 16% so far in 2024, driven by a handful of massive stocks poised to benefit from emerging artificial intelligence technology. Only 24% of stocks in the S&P 500 outperformed the index in the first half, the third-narrowest six-month period since 1986, according to BofA Global Research strategists.
Meanwhile, the equal-weight S&P 500 -- a proxy for the average stock -- is only up around 4% this year. As of Tuesday, about 40% of S&P 500 components were down for the year.
Second-quarter earnings kick off next week with major banks including JPMorgan and Citigroup reporting on July 12. Investors will be watching whether profits from other companies are catching up with the "Magnificent 7": Nvidia, Microsoft (NASDAQ:MSFT), Apple (NASDAQ:AAPL), Alphabet (NASDAQ:GOOGL), Amazon (NASDAQ:AMZN), Meta Platforms (NASDAQ:META) and Tesla (NASDAQ:TSLA), many of which rebounded from struggles in 2022.
Investors generally view a narrow rally as more fragile, because weakness in just a few big stocks could sink indexes, but some hope gains will spread during the second half.
More companies are projected to post improved earnings as many investors expect the economy to navigate a soft landing, which could boost stocks trading at more moderate valuations than market leaders.
"If we're looking for a catalyst to have broader participation in this rally this year, the second-quarter earnings reporting season may well be the start of that," said Art Hogan, chief market strategist at B Riley Wealth.
The S&P 500 is trading at about 21 times forward earnings estimates, but if the top 10 stocks by market value are excluded that figure drops to 16.5 on average for the rest of the index, Hogan said.
In a further sign of the narrow rally, the information technology and communication services sectors, which include most of the Magnificent 7, are the only two of 11 S&P 500 sectors to outperform the broader index this year.
Earnings among the Magnificent 7 rose 51.8% year-on-year in the first quarter compared to 1.3% earnings growth for the rest of the S&P 500, according to Tajinder Dhillon, senior research analyst at LSEG.
That gap is expected to shrink, with forecasts for Magnificent 7 year-on-year earnings rising 29.7% in the second quarter and earnings among the rest of the index up 7.2%, according to LSEG.
"We think greater balance in profitability could lead to broader market participation in the coming quarters," Chris Haverland, global equity strategist with the Wells Fargo Investment Institute (WFII), said in a note on Tuesday.
The WFII suggests investors trim gains in the technology and communication services sectors to take advantage of weakness in energy, healthcare, industrials and materials.
Later in the year, the Magnificent 7's profit advantage is expected to diminish further. The group's year-on-year earnings growth is expected to be 17.4% in the third quarter and 18.3% in the fourth. That compares with rest-of-index earnings growth of 6.8% in the third quarter and 13.9% in the fourth.
"We anticipate that we're going to have nearly all sectors of the S&P participating in earnings growth in 2024," said Katie Nixon, chief investment officer for Northern Trust (NASDAQ:NTRS) Wealth Management.
Not everyone is convinced that other groups are poised to catch up, as AI remains a dominant theme. Robert Pavlik, senior portfolio manager at Dakota Wealth Management, said he had doubts about earnings growth meeting expectations, due to weak consumer spending, sticky inflation and other concerning economic indicators.
Data on Friday showed U.S. job growth slowed marginally in June, with major stock indexes little changed in morning trade following the report.
In coming days, investors could get a clearer view of the economy's health and when the Federal Reserve will start cutting interest rates, which could also trigger broader market gains. Fed Chair Jerome Powell is due to testify before Congress on Tuesday, while Thursday's release of the monthly consumer price index provides a crucial look at inflation.