Different Shades of FAANGs

As markets remain at a major 1987 inspired inflection point, there are plenty of potential drivers that could prove decisive over the next few weeks and months. Traders were right this week to focus on US yields as a key player in this scenario, but probably wrong to believe the USD will continue move in synch – after all they diverged from 1987. They were similarly confused by commodities and dumbfounded by what stocks did at this point in the 1929 and 1987 style blowout. But it was clear what was happening to such stocks as Radio Corporation of America in 1929 and Intel in 1987 – complacent euphoria. Are Faangs telling us something now?

It’s hard to overstate the importance of Tech stocks, especially FAANG (or more specifically FAAMG, with the addition of Microsoft). Not only have they been the driving force of a large part of stock market gains, they are a symbol of America’s pre-eminence and innovation. In an ironic twist during Mark Zuckerberg’s testimony in Congress, someone secretly snapped his private notes, which used this very point in Facebook’s defence.

“Break up FB?  US tech companies key asset for America; break up strengthens Chinese companies,” the notes claimed.

The 5 stocks in FAAMG were responsible for around 40% of the S&P500 rally in H1 2017.

2018 is not shaping up quite as well as last year, but each year the market relies on a handful of stocks to do the heavy lifting. This is not a new phenomenon, but the contribution of the top ten is growing.

Clearly then FAANG/FAAMG is an essential part of the stock market, and they will rally or collapse together. But as the bull market continues in its ninth year, it is hard to imagine what could possibly go wrong for a stock like Apple. Its army of avid users will still queue round the block for the new iPhone and earnings would still make the mind boggle. Just last quarter, Apple reported the largest quarterly profit of all time. That’s the largest quarterly profit for any company in the history of the world.

And this was posted before tax reform has had an effect. Earnings season will give us a clearer idea on exactly how much of the reform filters through to the bottom line, but the net effect could be considerable; the graphic below gives us an idea on how EPS estimates for the S&P500 jumped higher when the tax bill was approved.

So what bearish thesis can there be?

FAANGs and the Economy
The FAANG stocks get bundled together, but really there are two types, or groups, identifiable by both their earnings and price performance. In the long term the differences are distinct.

Amazon and Netflix are stocks with little or no profit, hell bent on growth and rallying in a parabolic fashion. Apple, Google and Facebook, on the other hand, post solid earnings and have steadier, slower trending stocks.

An interesting feature of recent price action is that these differences have played out in the last week in a similar fashion. Again Amazon and Netflix have outperformed and Apple has underperformed.

Clearly these are different stocks, with different fundamentals, in different stages of development. But they are all reliant on the US economy in one way or another.

The recent parabolic rallies in Amazon and Netflix really took off after Q3 2017 earnings when tax reforms gained momentum. In its March statement, the Fed told us “the economic outlook has strengthened in recent months” and this accelerating growth, as seen by rising yields in the US and strong data in the eurozone, is what is fueling the current leg up in growth stocks like Amazon. US 10 year yields and Amazon are now joined at the hip.

By the same reasoning, if the economy slows, and the 10 year falls, Amazon likely follows.
You may ask why Amazon rallied in previous years when rates were low or falling, but correlations come and go depending on the stage of the economic cycle and a stock’s maturity. The Amazon rally is now reliant on the economy running slightly hot, and the way equity markets and yields interact are telling us the economy is late cycle.

Stocks like Apple are growing more slowly, but are still reliant on the economy for all kinds of reasons. iPhones could be classified as a luxury item, although some avid fans argue it is an essential item. Still, any item which costs over $700 when a comparable item with similar functions can be bought for half or even a quarter of the price is a luxury to most people. Sales are reliant on consumer sentiment and spending power.

Consumer sentiment tends to fluctuate in a 60-100 range over the long term. Dipping back to 80 or even 60 is bound to effect iPhone sales and Apple earnings.

What could cause this dip is another matter, and although consumer confidence and the markets are somewhat linked, there are many more inputs. We can see this in the UK as consumer confidence topped in 2015 despite the FTSE making new highs as recently as this year.

So Amazon, Netflix and Apple are all somehow linked to the economy, but what of Facebook and Google? After all, a recession won’t stop its users logging into Facebook or Googling for things on the internet. However, users don’t generate revenue; advertisers do, and advertisers are likely to cut back in downturns. The recession in 2008-2009 saw a dip in all types of media advertising revenues.

A dip in the economy is therefore likely to affect all FAANG stocks, but it is unlikely to be the actual trigger for a sell off. The catalyst may be much more subtle and fundamentals could remain strong into the top, just like in previous examples.

FAANG through the Ages
As we saw in the first section it is normal to have a handful of leading stocks in the S&P500 or Dow Jones. We may never have seen the likes of FAANG before – certainly not in terms of market cap – but every age has an equivalent and studying these stocks can help with our analysis. What is striking is that price action rarely changes.

A stock can have the solid fundamentals, and be growing impressively, but nothing is immune to a broader market shock like 1987 or 1929.

Walmart increased in value over three times in the 2.5 years leading into the 1987 top, just as Amazon has in the move from the 2016 lows. 1987 was a great year fundamentally according to its 10-K.

“TO OUR SHAREHOLDERS Fiscal 1987 was a year of significant achievement. Our sales, led by same store sales increases of 13%, surged ahead to record levels of $11,909 billion compared with $8,451 billion a year earlier, an overall increase of 41%.”

They may have added, “please ignore the 53% drop in share price; it wasn’t really our fault”.

Comcast is another stock to have more than tripled leading into the 1987 top, just as Netflix has now.

You could also pick stocks from the late 1990s such as IBM and Intel, or take GE and RCA from the 1920s.

Leading stocks and the stock market will rise and fall together, and fundamentals such as earnings will matter more when the correction finally completes than during the crash. Consider Intel and Microsoft dropped similar amounts from their highs in 2000, but Intel is now still below its peak while Microsoft is 60% above.

The leading stocks have changed but how they move in response to changing conditions… probably never will.

Here’s to making the very best.

Good Luck

Andrew McElroy
Chief Stocks Analyst
Matrix Trade

Ed Matts is away this weekend

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