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Narrator: Welcome. I'm Liz Ann Sanders, chief investment strategist at Schwab, and I'm here to chat with you about questions you have regarding the Mag seven and A.I., so, let's jump in.
Okay. Question. "What does it really take to be diversified these days? The S&P 500, Nasdaq, most large company growth funds, tech funds and a total market fund are all dominated by the Mag 7 companies." Interesting question. I would actually quibble a little bit because what was laid out in the question doesn't represent diversification. Actually what was named there are these large cap, mega cap, tech oriented growth areas. And that doesn't represent diversification. When we talk about diversification, we're talking about within asset classes, across asset classes, bringing in fixed income, bringing in international, bringing in alternative assets. So, we have to think about diversification in a larger context. We also have to be mindful of not just the concentration associated with the Mag 7, and that's an important one, but even concentration within individual sectors.
Image: Compares the percentage of the S&P 500 that the largest five stocks represent to the largest 10 stocks from 1990 to 2025. The largest 10 rose from just above 20% to just above 40%, while the largest five rose from just below 15% to just above 30%.
Narrator: So here are some numbers. The 10 largest stocks, which include the Mag 7 and a few others. So the 10 largest stocks now represent 40% of the S&P 500®. It's a cap weighted index. Those same 10 stocks represent 60% of the Nasdaq®. But you develop concentration even within the sectors represented by the Mag 7. So of the seven stocks, three of the stocks Apple, Nvidia, and Microsoft are in the technology sector. Those three stocks account for 60% of that sector. In the consumer discretionary sector, which houses Amazon and Tesla, also, those two stocks represent 60% of that sector. And then in the communication services sector where you have Google or Alphabet and Meta, 75% of that sector is represented by just those two stocks. So, keep that in mind when you think about diversification and concentration.
A lot of investors look to get exposure to sectors by buying a sector-based exchange traded fund or ETF. Keep in mind that many of these sector ETFs have limitations on how much the fund can own in any one stock. Which means buying just say, a communication services sector ETF doesn't mean you're going to track the performance of the actual sector because of limitations of how much can be owned of any one individual stocks, and that's why sometimes there's a performance spread between what the sector is doing and what the sector ETF is doing.
Okay. Next one. "I am very interested in how much the mega-cap IPOs planned for 2026, as an example, SpaceX, OpenAI, Anthropic, will put pressure on the prices of other stocks for example Mag 7 due to the overall reallocation."
The short answer is we're not sure yet. First of all, a lot of these are just pending. We don't know the dates associated with that. There's often I find there's often an assumption that when you get these mega cap IPOs, because they're such large companies or profitable companies, that they would quickly get added to an index like the S&P 500. That is not the case. There are certain parameters that have to be met. So we don't know the point where they go from being newly traded companies on the public markets into, say, an index like the S&P 500.
But frankly, it might not be a bad thing. You know, in the prior question, we touched on the concentration problem and how dominant a lot of these companies have become in their weighting in overall indexes, in their weighting in sectors. You bring some additional companies in there, it might actually have a and I don't mean this in a negative way, a diluting effect and maybe help to alleviate some of that concentration.
Again, it may not work itself immediately into alleviating the concentration within an index like the S&P, at least until the point that one or some of these stocks ultimately would get added to an index like that.
Okay, another Mag 7 question. "To what extent is the Mag 7 leadership debate really a liquidity/rates story rather than a fundamental one? And how do you separate cyclical rotation from regime level leadership change in real time?" So, the first one is a little more narrow part of the question then a broader question. So, I think, you know, any bull market like the one that we have been in, there's certainly a liquidity story typically embedded in a bull market. In this case, I'm not so sure the rate story has been a big driver of this bull market, where I do think the rate story has come into play. And this was in the middle part of 2025 when there was first the telegraphing of easier fed policy to come. That I think gave support to smaller cap indexes because they tend to be more sensitive to what interest rates are doing.
Image: Shows capital expenditures and transactions rising from $0 in 1950 to more than $9 million in 1955 for all sectors. Also shows U.S. recessions during that period.
Narrator: I don't really think it's been a big driver. I think the fundamentals have been the driver of some of the mega-cap leadership that has defined an index like the S&P 500, and in the case of the Magnificent Seven, you've had a fundamental story of exceptionally strong earnings growth, that has been the fundamental driver. You've got the capital spending story, just the boom in capital spending, which the good news is, until recently, that huge amount of capital spending has been financed out of cash flow, has been financed out of equity gains. It has not been financed on the debt side. That is shifting now. That's something to be mindful of. The last thing I'd say though, this is important because it brings up a mantra of mine that I that I've said over and over again in my 40 years doing this, and I'll say it first, and then I'll explain it in the context of this question. Better or worse, often matters more than good or bad. What I mean by that is it's human nature for us to think, whether we're talking about an earnings report or an economic report that comes out or an earnings growth rate, we tend to think, was it strong or was it weak? Was a good or was it bad? But it's the direction of travel that can matter.
And one of the reasons why we're seeing recent underperformance on the part of a cohort like the Mag 7 is not that their earnings growth rate is now subpar to the rest of the S&P 500, but the earnings growth rate has been decelerating from more than 60% year over year growth a year and a half to two years ago, now down to more like 20% growth, where the rest of the market has actually been an accelerating, still lower growth in an absolute sense, but it's that direction of travel that matters a lot as well.
So, second part of the question is bigger picture, you know, cyclical rotation versus regime change. You know when you're in the moment, it's impossible to know whether we're just in the midst of yet another series of rotations or whether there is some sort of regime change. I lean at this point, a little more toward these are cyclical rotations. We're in a very rotational market. There's a lot of shorter-term money moving around in the market. Retail traders looking for the shiny new object rotation has almost become the momentum trade. The other day I said something on TV that captured a lot of people's attention, actually on fintwit where I said it's not only traders and shorter term investors looking for the shiny new object, but they're also looking for what's the dull new object. So defining where money is moving in and out of. And I think that kind of rotational market, that I think will stay with us for a bit, it's too soon to know whether that's some sort of representation of a true, more secular regime change.
Okay, here we go. "I hope you can touch on the issue of circularity. For example, Nvidia investing in CoreWeave, then CoreWeave using the funds to buy Nvidia chips. Why is this something the market does not seem to appreciate?" Very interesting way to ask that question. I get questions about the circularity, but it's more of their positive angle to the question of why don't people appreciate the benefits to that? I think we need to look at the issue of circularity, both in terms of the benefits, to the point they're sort of making investments in companies that sort of guarantee that they represent a buyer for what they're producing, in this case, chips. So yes, that's part of the beneficial aspect to the circularity. The other side of that though, I think, is because of the experience that many investors and analysts and people in the business had back in the late 1990s. It wasn't really called circular financing back then. It was called vendor financing. And I think the difference between the vendor financing era, which ultimately came to a head and was part of the reason why we had the dot.com bust in the two-and-a-half-year bear market that followed.
Image: Chart shows how Nvidia with $4.5 trillion in spending, and OpenAI with $500 billion, fund much of the AI money machine.
Narrator: One of the differences, and maybe this brings back some good news into the mix, is that a lot of the build out, in that case, of the sort of telecom infrastructure, the money that was being spent, tied into the vendor financing was alongside expectations for future demand. It wasn't tracking actual demand at the time. That's what's different this time. Most of the spend tied into the circular financing has been tracking alongside demand in the here and now. That doesn't though, mean that you might not get to a problem where, you know, the music stops and not everybody has a seat to sit in. And one of the things I would say to focus on is, as I touched on earlier, we've had an environment where a lot of the capital spending associated with AI has been financed out of cash flows.
Here's what's shifted, though, in the last year and a half. Free cash flow growth. The growth rate in free cash flow for the Mag 7 was running at about 65% to 70%. The last two or three quarters in a row, that's been in slight negative territory, which is part of the reason why some of the deals that have been announced, not just in the circularity of financing, but broader deals to finance capital spending, have been done with debt.
And you've had a couple of blow ups, concerns about default risk. We're not at a crisis moment by any means, but that's what I'd say to pay attention to, is look at how some of these ongoing deals are being financed, and whether you start to get more questions about the quality of debt being used to finance, some of these deals.
Okay. Next one: "If the markets AI trade narrows to one or two clear winners, what happens to market breadth? Are we headed toward a winner take most tape? And how should investors think about diversification when index concentration is already high?" Well, I'm going to take the other side of that. The opposite is actually happening. We're seeing a broadening out in the market, and it's not really just a broadening out because people are putting AI in the rearview mirror and they're looking for other broad themes.
Chart: 3 C's of AI's progression. Create, which includes invention and innovation; that includes picks and shovels, chatGPT rollout, Capex acceleration, old economy recession, concentrated market leadership, hyperscalers/chips. Catalyze, which includes buildout & infrastructure; that includes data center buildout, power grid investments, industrial automation, low hiring/firing, earnings expectations reset, infrastructure plays. Cascade, which includes impact and disruption; that includes widespread adoption, productivity gains, SaaS margin pressure, rapid fire sector rotations, earnings versus narrative driven, beneficiaries versus disrupted.
Narrator: AI is actually one of the themes associated with the broadening out, and I have been writing about recently and talking quite a bit about what I think of as the three C's in terms of phases we've been in associated with AI. So the first phase was the create phase. That was the early days of ChatGPT and the hyperscalers the creation of the thing we now know of is AI. Then we went into the catalyze phase, which is really the build out of AI, and that brought in data centers and energy needs. Now, I think we're in the cascade phase of AI where it's cascading into the economy in both a good way, in the sense that we're seeing who the beneficiaries are, and that spans across industries and across sectors and across companies, and the benefits accruing to productivity or profit margins, ease of doing business, etc., etc..
But there's also the cascade associated with where there's disruption, and that's just a natural part of an innovation. But I think AI and thinking it in broader terms, in the cascade terms, where are there opportunities? Again, across companies, large and small industries, outside of tech, how are you using AI? How are you bringing it into your business? What does it mean for your labor costs? What does it mean for your productivity, for your profit margins that's helping to broaden the market? In the past year, only 20% of the constituents within the S&P 500 outperformed the overall index itself. In the last month, that's more than 60%. So, we are seeing a broadening out. But it's not because AI is not a theme anymore. AI is very much embedded in a theme associated with broadening out.
What great questions. Thanks for sending them in and keep them coming. You might just be the inspiration for the next comment below video. And remember, you can find more great educational content at schwab.com/learn or on our YouTube channel, @CharlesSchwab.
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