No Nvidia in your portfolio? ‘You’re just toast’

In this year’s bull market, there are artificial-intelligence plays like Nvidia—and then there’s everything else. As the second half of the year begins, investors are wondering whether something has to give.

Enthusiasm for the chip maker, whose products are seen as essential to powering AI technology, kept building through the second quarter. Nvidia reported sales and profits in May that blew past Wall Street expectations for the fifth consecutive quarter. The stock rose 37% in the second quarter and is up 149% for the year.

Much of the rest of the index has languished. The average stock within the S&P 500 is up 4.1% this year, while the broad index is up 14.5%. That is the largest underperformance since at least 1990, according to Dow Jones Market Data. Six of the 11 sectors in the index declined in the second quarter, including financials, energy and industrials.

The divergence has some value investors throwing up their hands.

“We can’t keep up because we don’t own Nvidia,” said Max Wasserman, co-founder and senior portfolio manager at Miramar Capital. “If you don’t own that one stock, it really hurts. Every day feels like a root canal without novocaine.”

Investors are bracing for volatility in the second half of the year. They continue to expect the Federal Reserve will move to cut interest rates before the end of 2024, and stocks could fall if that hope proves premature. The presidential election means government policy is uncertain in key categories like taxes and energy. President Biden’s halting debate performance last week could further muddy the waters. And Wall Street analysts expect strong corporate earnings growth, which might not materialize.

Nvidia was the largest gainer within the S&P 500 last year and has more than tripled in value over the past 12 months. Its market value hit $3 trillion in June, less than four months after it reached the $2 trillion mark.

The group of big technology stocks known as the Magnificent Seven—Nvidia, Microsoft, Apple, Amazon.com, Meta Platforms, Alphabet and Tesla—is responsible for 60% of the index’s total return this year through Wednesday, according to S&P Dow Jones Indices.

Investors have flocked to big tech stocks in part because they are increasing their earnings more quickly than the rest of the market.

“It makes sense to me that we are packed into a lot of these AI plays because that’s where people feel like there’s secular growth,” said Julie Biel, chief market strategist at Kayne Anderson Rudnick. “Even if you do a great job in the rest of the portfolio, if you’re not overweight in the same place, you’re just toast.”

Wall Street analysts project companies in the S&P 500’s information-technology sector will increase earnings by 16% in the second quarter from a year earlier, according to FactSet, while earnings in the communication-services group—home to the likes of Alphabet and Meta—are forecast to grow by 19%. Analysts project less than 9% overall growth for the S&P 500.

A foggy economic outlook is one reason that most stocks are subdued, Biel said.

The blue-chip Dow Jones Industrial Average has advanced 3.8% this year. The Dow Jones Transportation Average, which tracks 20 large U.S. companies in industries like trucking and railroads, is down 3%. The Russell 2000 index of small and midsize companies is little changed.

Inflation has been more persistent than most investors had hoped entering the year. The Fed has held interest rates steady so far this year; many on Wall Street had expected the Fed to cut rates as many as six times when the year began.

But prices have increased at a slower rate recently, raising hopes on Wall Street that the rate cuts could finally materialize. The Fed’s preferred inflation gauge was unchanged in May from the prior month, the Commerce Department said Friday.

Although Nvidia’s sharp rally has conjured memories of the dot-com era, some investors said there isn’t a bubble forming in the market this time around.

“There’s been some differentiation from investors,” said James Hagerty, chief executive of Bartlett Wealth Management. “Some stocks got hit very hard when earnings were very good but didn’t quite meet expectations.”

Nike shares fell 20% on Friday after the apparel maker cut its revenue forecast. Chip maker Micron fell 7.2% on Thursday after unveiling sales guidance that disappointed investors.

The stocks in the Magnificent Seven trade at an average of 37 times their expected earnings over the next 12 months, according to FactSet. The S&P 500 trades at 21 times.

Investors said Nvidia can keep rallying as long as sales and profits keep topping expectations. But high valuations have left the chip maker with little room for error.

“My guess is when Nvidia comes back to earth, it’s going to come back quickly,” said Brian James, managing partner and director of investments at Ullman Wealth Partners.

Write to Charley Grant at charles.grant@wsj.com