Why the "Magnificent Seven" Trade Is Starting to Fracture, and Where You Should Invest Instead

Investors have a bad habit of following the crowd, which is why the term lemmings is often used on Wall Street. Everyone piling into one trading idea often leads to huge media attention and fun nicknames for the hot investment themes. One of the most recent ones is the Magnificent Seven. There's even an exchange-traded fund (ETF), Roundhill Magnificent Seven ETF (NYSEMKT: MAGS), that you can buy.

It really shouldn't be surprising that the Magnificent Seven stocks, Alphabet (NASDAQ: GOOG), Amazon (NASDAQ: AMZN), Apple (NASDAQ: AAPL), Meta (NASDAQ: META), Microsoft (NASDAQ: MSFT), Nvidia (NASDAQ: NVDA), and Tesla (NASDAQ: TSLA), aren't going to be eternally on the rise. That's just not how markets work. Here's what you need to know about the tech-driven Magnificent Seven and where you might want to invest instead.

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Trees don't grow to the sky

There was once a group of 50 stocks that investors believed were unstoppable. All you needed to do was buy those 50 stocks and hold on forever. The stocks even got a cool nickname: The Nifty 50.

Some of the companies on that list have done very well over time, such as International Business Machines (NYSE: IBM), while others have not, like Polaroid, which went bankrupt. However, none of the Nifty 50 stocks were the sure things investors believed them to be. Wall Street and the business cycle just don't work that way.

From the Wall Street side of the equation, the old saying that trees don't grow to the sky is important to keep in mind. Investors tend to pile into an investment theme, pushing prices and valuations higher. That draws in more investors, pushing prices and valuations even higher. That can only go on for so long before the prices are detached from the value of the underlying investments. Eventually, investors grow worried and sell, often causing the bubble to implode.

From a business perspective, companies invest in an attractive opportunity. That draws in more investment, and eventually it seems like every business is trying to get in on the action. The dot-com bubble at the turn of the century was a great example, with companies just appending ".com" to their names to get attention. But when too many companies are chasing the same investment idea, returns start to decline. And sometimes there is overbuilding, which leads to a business bubble that bursts.

The Magnificent Seven was doomed from the very start to fracture. The only real question was when, either from investor exuberance or corporate exuberance (or both). This is just a repeat of Wall Street history, for investors who care to examine the past.

Go back to basics instead of hyper-focusing on AI

The core story behind the Magnificent Seven is the rapid growth of artificial intelligence (AI). AI is real, but there are other investment opportunities in the market. One area that you might want to consider is consumer staples stocks, as you, perhaps inevitably, watch the Magnificent Seven story break apart.

Companies like Procter & Gamble (NYSE: PG) and Coca-Cola (NYSE: KO) make relatively low-cost products that consumers buy regularly. Many are considered necessities of life, such as P&G's toothpaste and toilet paper. Others, such as Coca-Cola's soda, are affordable luxuries that meet basic human needs (food).

Both P&G and Coca-Cola rank among the world's largest consumer staples businesses. Both have proven they can survive the entire business cycle, as each is also a Dividend King with 50+ consecutive annual dividend increases. P&G's yield is an attractive 3% right now, while Coca-Cola's is 2.4%. Neither company is as exciting as an AI-driven Magnificent Seven stock, but they will most certainly use AI extensively if it helps their businesses perform better.

P&G's price-to-earnings ratio of 22x is below its five-year average of 25x. Coca-Cola's P/E of 26x is roughly in line with its five-year average. So neither one looks overextended at the moment, if you are looking to diversify your portfolio away from high-tech companies and toward businesses that sell basic necessities and that tend to hold up well during market storms.

It isn't bad to invest in AI, but you need to temper your enthusiasm

It isn't wrong to buy one of the Magnificent Seven stocks, or even Roundhill Magnificent Seven ETF, but you shouldn't invest only in hot AI-related stocks. You should create a diversified portfolio that includes a broad range of investments. Right now, if you find you are overweighted in the Magnificent Seven, you may want to consider boring but reliable businesses like P&G and Coca-Cola. They're reasonably priced, offer attractive yields, and have a long history of surviving through the market's and economy's normal ups and downs.

Reuben Gregg Brewer has positions in International Business Machines and Procter & Gamble. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, International Business Machines, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool has a disclosure policy.