PMC Weekly Review - April 20, 2018

A Macro View: “Trendy Tech and its Impact on Markets: Could Indices be De-FAANGed?"

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
Investment Analyst

Source: Bloomberg

Download the full PDF

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.

Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.

Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.

Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.

© 2018 Envestnet. All rights reserved.