PMC Weekly Review - April 20, 2018
Investors who have been tuned into the latest financial news likely would have noticed the headlines that technology-related stocks are garnering yet again. In recent weeks, volatility has come back to these stocks, leading investors to question whether their multiyear advance will continue.
The five largest components of the S&P 500 Index (the broad US large cap equity market index used by most investors), are technology or technology-related names. Apple (AAPL) represents about 3.9%; Microsoft (MSFT) about 3.2%; Amazon Inc. (AMZN) about 2.5%; Facebook Inc. (FB) about 1.7%; and Alphabet Inc. or Google (GOOG and GOOGL) about 2.8%. Netflix (NFLX), 0.6% of the S&P 500 Index (the Index), another popular tech stock, is the final piece of the so-called “FAANG” stocks that have been very topical in recent years. In fact, the roughly 15% of the Index that these five names occupy is about the same weight as the Financials and Health Care sectors or more than each of the Consumer Discretionary, Consumer Staples, Energy, Materials, Telecommunications, and Real Estate sectors. The sheer size of these stocks suggests the gains or losses of these tech names should continue to have a pronounced impact on both the market and on all investors active in it.
The disproportionate size of these popular tech names in conjunction with their relatively high valuations pushes up valuations of the total S&P 500 Index. Therefore, if or when a true correction occurs within the FAANG stocks, the total valuation of the S&P 500 Index will suffer. So it seems the further these tech stocks rally, the harder it becomes for the rest of the stocks that comprise the S&P 500 Index to buffer against a potential selloff of the FAANG stocks.
Additionally, fans of simple behavioral investing can understand why the FAANG names have gathered investors’ dollars. Simply stated, these intriguing companies are at the forefront of innovation and are involved in such things as cloud computing and artificial intelligence. Who doesn’t want to get involved with a company like that? But investors need to think about what could occur if the excitement around these names wavers. Would they really transition their investments from an industry-disrupting company like Amazon to less exciting brick-and-mortar retailers? And what impact would that decision have on the broader equity markets? Would equity investors take their investing dollars elsewhere?
Amid this complex situation, it is also inevitable that investors will revert to past memories and compare this tech rally and the euphoria for some companies with the dot-com collapse of 2000, as technology stocks then too became an increasingly larger portion of the market’s weight prior to the collapse.
So are there reasons why investors should feel some comfort about the tech stocks of today? Well, yes. From a technical standpoint, we haven’t seen a surplus of tech initial public offerings (IPOs) like we did leading up to 2000. And regarding fundamentals, it seems clear that investors should worry most when earnings can no longer support valuations. The tech stocks at the pinnacle of the dot-com rally represented more than 30% of the S&P’s market capitalization, but were generating only about half that percentage of its net income. Tech stocks currently represent nearly 25% of the S&P’s market capitalization and produce a similar percentage of its net income, indicating that tech stocks today are more profitable on a relative scale and represent a lower percentage of the market than they did leading up to 2000.
Some key changes are coming to the tech sector that will affect their perceived dominance in indices. This September, major index providers MSCI and Standard & Poor’s will recategorize components within their indices. So within the S&P 500 Index, for example, many of the current Information Technology sector names (including Facebook and Google) will be reclassified into a new sector to be called Communication Services. Following such reclassifications, the Information Technology’s sector weight in the S&P 500 Index should decline to about 20% from 25%, reducing at least the appearance of the Index’s technology concentration.
After digesting these facts, it seems clear investors need to remain conscious of the continued impact of megacap tech stocks on global markets, but it seems the likelihood of truly de-FAANGed indices is fairly limited.
Michael Manning, CFA