AI laggards gain traction as fatigue sets in for Magnificent Seven

Wall Street is looking beyond the obvious megacap stocks to find the next leg of the artificial intelligence trade.

Betting that the Magnificent Seven may be running out of steam after an 18-month rally, some investors are turning their attention to what Melius Research dubbed “AI laggards.” This group, which includes Intel Corp., Advanced Micro Devices Inc., and International Business Machines Corp., have exposure to the AI theme but failed to keep up with gains for the biggest AI winners in the first half of the year. 

All three have outperformed over the past month, while AI poster child Nvidia Corp. has slightly dropped in that period. Chip stocks broadly fell Wednesday after Bloomberg reported that the Biden administration is considering using the most severe trade restrictions available if companies continue giving China access to advanced chip technology, although Intel rose 6.6%.

IBM shares swung between gains and losses in early trading Wednesday, after five days of gains.

Crucially, the laggards also have lower valuations and bars to clear in terms of sentiment and earnings expectations, suggesting they could be well positioned for the rest of 2024.

“We are believers in a ‘catch-up’ trade for some in semis, hardware and even software — those with lower expectations,” Melius analyst Ben Reitzes wrote in a note this month, adding that a similar pattern occurred in 2023, when first half “underdogs” did well in the second half.

Reitzes also included Apple Inc. on his list of stocks that underperformed in the first six months. Shares in the iPhone maker have been rising steadily since April, preceding the rotation into other laggards, but have been especially strong since Apple demonstrated long-awaited new AI features last month.

Ted Mortonson, a technology desk sector strategist at Baird, said investors are starting to rotate into stocks where fundamentals are strong but expectations are lower, leaving more room for upside.

“The obvious AI stocks have doubled over the past year and are facing slower growth from here,” he said. “It doesn’t take a rocket scientist to think they’re over-owned and that there might be a catch up in names that have been overlooked.”

Mortonson highlighted other stocks he sees as beneficiaries of the trade, including software company F5 Inc., electronic measurement instruments company Keysight Technologies Inc., and semiconductor-related firms Diodes Inc., Coherent Corp., Lumentum Holdings Inc. and Aehr Test Systems, which on Tuesday gave a positive outlook.

The rotation is coming after a first half which saw megacaps including Nvidia, Microsoft Corp. and Alphabet Inc. propel the market higher, stretching valuations for these names and leaving them with a tougher setup for the rest of 2024. Citigroup analysts recently suggested investors take profits in some high-flying AI stocks and “re-balance toward a broader array of AI stocks across the value chain.”

Earnings growth for the Magnificent Seven is expected to decelerate next year, according to Bloomberg Intelligence. At the same time, AI winners like Nvidia and Microsoft are trading at substantial premiums to their long-term multiples — making laggards like IBM and Intel look like bargains in comparison.

IBM’s second-quarter results next week will be an important datapoint to determine whether this trade can continue. Last quarter, weak sales from the company’s consulting unit sparked the biggest one-day drop in more than two years. While megacap stocks have been hitting record after record this year, IBM hasn’t hit one since 2013.

“Everyone owns the growth tech stocks, but the value side has been neglected at a time when the macro cycle should be pretty favorable,” said Ohsung Kwon, equity and quantitative strategist at Bank of America.

“There’s definitely a trade to be made within tech, since positioning has gotten pretty extreme.”

The recent strength in small-cap stocks includes tech, with the category trouncing its larger equivalent of late. An index tracking small-cap tech jumped 3% on Tuesday, its biggest one-day gain since December, even as the large-cap tech index fell 0.4%. While large-cap remains the decisive outperformer this year, the past month has favored smaller names. The small-cap tech index is up more than 10%, compared with a 3.8% rise for large-caps.

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Earnings Due Wednesday

• No major earnings expected