As U.S. tech giants prepare to report their earnings this week, a slowdown in profit growth is removing some of their invincible aura. Whether this trend can be reversed will largely determine whether the stock market's upward momentum can continue.

Data compiled by Bloomberg Intelligence shows that the five most valuable companies in the S&P 500 index—Apple (AAPL.US), Nvidia (NVDA.US), Microsoft (MSFT.US), Alphabet (GOOGL.US), and Amazon (AMZN.US)—are expected to see an average profit growth of 19% in the third quarter. Although this will easily exceed the expected profit growth rate of 4.3% for the S&P 500 index, it will also be the slowest overall profit growth rate for these five companies in six quarters.

Furthermore, it is expected that by 2025, the profit growth gap between large technology companies and other companies will continue to narrow. By that time, the approximately 35% quarterly profit growth rate that these large technology companies achieved last year will become history. Therefore, the question facing investors is what this means for these large technology companies and whether they can continue to lead the U.S. stock index higher.

"The market sentiment is much more volatile than in the past few quarters, and the factors driving the market now feel more negative," said Andrew Choi, portfolio manager at San Francisco-based Parnassus Investments. "This does not mean that the upward trend has ended, but there are opportunities elsewhere, especially when we argue about the valuation of large technology companies, the slowdown in profit momentum, and other issues. Now, every story has some controversial or argumentative factors, which will affect market sentiment."

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1. Market rotation

For most of the past two years, tech giants have led the rise of the S&P 500 index, due to their expanding profits and investors' willingness to continue paying higher yields for these profits.

However, the situation has changed in recent months. Since peaking on July 10, the Bloomberg Magnificent 7 Index—comprising the aforementioned five tech giants as well as Meta (META.US) and Tesla (TSLA.US)—has fallen by 2%. This performance lags behind all major sectors of the S&P 500 index during the same period, with utilities, real estate, financial, and industrial stocks rising by more than 10%, and the overall index rising by 3.1%.

All of this puts large technology companies in an unfamiliar position: at a disadvantage in the stock market. As valuations rise, they are facing stricter scrutiny, and investors question when the huge spending on artificial intelligence projects will pay off.

"The situation where technology stocks lose market leadership may continue until the end of this year, but it will not scare us into giving up on holding them for the long term," said Ross Mayfield, an investment strategist at Baird. "There is obviously a risk of slowing profit growth, and valuations may be a bit high, but they can still bring so much growth, and there is still a lot of room for profit potential in the next few years."Tesla has reported better-than-expected third-quarter results and provided encouraging guidance. Other major technology companies will announce their earnings this week. Alphabet will release its earnings on Tuesday, followed by Meta and Microsoft on Wednesday, Apple and Amazon on Thursday, and Nvidia is expected to report its earnings towards the end of November.

2. The Future of Artificial Intelligence

The tech giants reporting earnings this week each have their own set of issues. Microsoft is facing concerns about its prospects in the field of artificial intelligence. Apple has seen initial signs of lukewarm demand for the latest iPhone, although long-term optimism has driven the company's stock to a new high last week. Amazon's investors are worried that the company's substantial capital expenditures will erode profits. Meanwhile, Alphabet faces regulatory uncertainty as the U.S. Department of Justice investigates the company for monopolistic practices.

Artificial intelligence will be a significant focus for investors, especially as these companies have invested heavily in expensive AI infrastructure. In the third quarter of this year, capital expenditures for Microsoft, Alphabet, Amazon, and Meta are expected to reach $56 billion, a 52% increase from the previous year.

Investors widely believe that the AI investments of these companies represent the future of technology. However, there is little evidence to suggest that companies like Microsoft, which have already integrated AI capabilities into their software products, will see an immediate surge in profits. Disappointment in the gap between AI spending and performance marred the second-quarter earnings season. Now, it raises concerns about future profit margins.

Bloomberg Intelligence strategists Gina Martin Adams and Michael Casper stated, "Profit growth is beginning to be offset by the surge in AI-related capital expenditures. This means that profit margins are likely to have peaked, at least in the short term."

3. Valuation Conundrum

Despite the apparent decline in the stock prices of large-cap stocks, many of these companies are valued above historical averages. Data shows that Apple's expected price-to-earnings ratio for the next 12 months is 32, compared to an average of 20 over the past decade; Microsoft's expected P/E ratio is 33, compared to an average of 25 over the past decade.

Bellwether Wealth Chief Investment Officer Clark Bellin said, "If you're looking at tech stocks, you have to ask, is their earnings growth really enough to catch up with these P/E levels? Or is some of the recent strong performance reflecting investors' fear of missing out?" "You can't ignore the impact of momentum, but at some point, the 'music might stop'. People need to manage their expectations during earnings season."

It is certain that Wall Street professionals still overwhelmingly favor large technology companies. Data shows that about 90% of analysts following Microsoft, Alphabet, and Nvidia have given "buy" ratings to these companies' stocks, compared to about 53% for S&P 500 component companies.Andrew Choi stated: "The reasons for optimism are quite straightforward. Despite various concerns, they still offer above-average earnings growth, exposure to artificial intelligence, strong capital returns, and lower risk compared to other stock market sectors." "It is hard to find businesses with such rapid earnings growth; there are many things to like about them."