I know I sound like a broken record, but it appears that, once again, a market rotation could be underway. The S&P 500 Information Technology sector reached an all-time high last Thursday, August 6th. The same is true for the S&P 500 Communications Services sector, which contains Facebook, Alphabet (Google) and Netflix. As I’ve noted many times in previous Market Commentaries, the Information Technology sector and the FAANG stocks within the Communications Services sector have been responsible for an enormous amount of S&P 500 overall index returns this year (Amazon is in the Consumer Discretionary sector, but I will ignore that technicality for simplicity). The massive disparity between the market-leading FAANGs and the market-lagging cyclical sectors like Industrials, Energy and Financials has triggered an enormous amount of media speculation about 1) the possibility of a bubble in the FAANG stocks; and 2) the timing of a potential rotation out of the FAANGs and into the more cyclical laggards. This topic is not unique to 2020 – the FAANGs (we include Microsoft) have been leading the market higher for several years now. But the sheer enormity of FAANG stocks’ combined market capitalization (nearly $7 trillion as I write), is starting to make some very successful and high-profile investors a little nervous. Will the anxiety spread?
My belief is that a meaningful rotation out of the FAANGs won’t occur until certain conditions are met. The investment allure of the FAANG stocks is underpinned by a couple of factors, and it’s not at all clear to me, at least, that those factors are on the verge of changing in a meaningful way. First, the huge scale of the COVID-induced recession has left equity investors with very few options that offer growth. The FAANG stocks have not only maintained their earnings power throughout the downturn, but they have actually benefited, in most cases, from social distancing and confinement to the home. Once it becomes clear that the economy is on a firmer foundation and stay-at-home orders begin to get lifted, money will start to flow back into the economically sensitive stocks and sectors that have been roundly shunned since COVID hit our shores. Whether that money comes from the sale of FAANG stocks is more difficult to predict.
Another important reason for the FAANG stocks’ rise to meteoric heights is the huge drop in interest rates. Ultra-low interest rates have been good for FAANG stocks because low rates reduce the cost of owning securities that don’t offer positive cash flows until well out into the future. Said another way, the opportunity cost of owning “growth” stocks with little or no dividends is much smaller if you can’t earn a respectable return on your money through other investments. So given the FAANGs’ earnings resiliency relative to other sectors and the inability to earn returns from other asset classes, money has poured into the FAANGs with reckless abandon.
So what needs to happened before the FAANGs start to lose their halos? First, there needs to be more visibility with regard to the pace of recovery in employment and the economy at large. It seems fairly obvious at this point that initiatives to reopen the economy in many regions of the country were premature. A resurgence in infections has occurred, and folks across much of the US have understandably reverted back to either mandatory or self-imposed quarantine. That process has stalled the economic recovery, according to most economists. And so the road to greater economic visibility starts with Congress passing a fourth round of economic stimulus. Economic assistance for businesses and consumers is absolutely imperative if we are to bridge the gap until such time that successful vaccines and therapeutics are developed, approved and administered.
Second, longer-term interest rates will probably have to rise more than the few basis points (a basis point a 1/100th of a percent) we’ve seen over the past couple of days. It may seem unlikely right now that interest rates will rise meaningfully anytime soon. The Fed’s repeated commitments to keep interest rates low indefinitely have put downward pressure on longer-term interest rates over the past few months. At the same time, there isn’t much evidence that inflation will become a problem anytime soon. This week we learned that the Consumer Price Index (CPI) rose just 1.6% year-over-year in July if we exclude the volatile categories of food and energy – a little bit higher than expected but still comfortably below the Fed’s target of 2%. Inflation is not a problem right now, but could this week’s higher-than-expected CPI reading and the recent spike in commodities like gold, silver and copper be the initial signs of a worrisome trend? Time will tell.
I need to stress that just because the conditions for a rotation out of FAANGs and into cyclicals aren’t in place just yet, that doesn’t mean things can’t change very quickly. If investors begin to determine that the economic rebound is on firmer footing, creating higher demand and therefore upward pressure on prices, the impact on stocks that have benefited from low interest rates and the economic lock-down, like the FAANGs, could be quite negative (at least at first). And then there will be a slew of momentum traders that pile on, trying to make money shorting the FAANGs as they begin their decent from astronomical highs. Because the potential pain of being on the wrong side of that trade could be sizeable, it is imperative that investors ensure that their holdings have strong fundamental and valuation support. Not all FAANGs are created equal, and now is the time to distinguish!