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In Deep Dive #001: FAANGM Impact, we will put recent market performance into context, discuss market breadth, explain features and nuances of market-cap weighted indexing, contrast FAANGM with the late-90’s tech bubble, and offer our takeaways.
FAANGM: The Setup
Humans love a good story. The financial industry is no exception, and “FAANGM” is a great headline. FAANG is shorthand for the stocks of Facebook, Amazon, Apple, Netflix, and Google (parent company Alphabet, Inc.). Microsoft was a late addition, giving us the final FAANGM six-pack this Deep Dive addresses. These six companies are among the largest in the world and given their visibility to consumers, it is no surprise their strong performance has dominated financial news.
With strong returns for so few companies, especially in the context of market capitalization-weighted benchmarks, we are fielding concerns that the market may be narrowing. Are FAANGM stocks propping up a market ready to tumble as a sort of Tech Bubble 2.0? Are FAANGM returns papering over trouble for the broader economy? All are reasonable questions and ISR believes all have relatively benign answers.
As of Friday, July 20, the S&P 500 is up +5.9% on a total return basis (TR for short; includes dividends + capital appreciation). Consider the chart to the left. Here we break contribution to S&P 500 TR into three distinct categories: FAANGM performance (all positive), positive non-FAANGM stocks, and finally, all negative stocks. We can see that FAANGM has contributed +3.5% to the index’s +5.9% TR. This is nothing to sneeze at, but it is much less than the +5.9% contributed by non-FAANGM positive performers. After accounting for the negative stocks, which contributed -3.5%, we arrive at 5.9% TR for the S&P 500, a strong number halfway through a volatile year. It may be catchy to say that 59% of the market’s return is attributable to FAANGM, but we believe this assertion lacks proper context.
Narrowing leadership can portend market declines, if/when the few leaders finally falter. It can often be a warning sign that economic conditions are softening, and that most companies are not doing well. Given the pervasiveness of the FAANGM narrative with the market still grinding away in correction territory, concerns on this front are reasonable. However, we believe the data is not particularly ominous.
Our data on attribution might assuage some concerns on breadth. To illustrate we first present the table to the right. Each of the FAANGM stocks (Google has two share classes) has indeed shown strong total return YTD. Aside from Netflix, however, the FAANGM stocks are not even top performers in their own sector. FAANGM have been the six most impactful issues to overall S&P 500 performance, but this cap-weighted gauge of the market is not necessarily a good way measure breadth.
We believe a better way to view market breadth, and a better way to make assertions on the broader health of the economy, is to look at more balanced metrics. In our view, breadth looks healthy. YTD, around 60% of the stocks in the S&P 500 are positive. The Russell 3000, which covers ~98% of US market capitalization, tells a similar story: over 61% of constituents are positive YTD.
Looking at breadth through another lens, consider the graph to the right, which breaks down YTD S&P 500 average TR by decile based on average weighting in the index.
The largest-cap stocks of the first decile have strong performance, but are trailing the third and sixth deciles, which would be approximately the 101st-150th and 251st-300th most impactful stocks to overall index performance. The fifth and ninth deciles could be considered disappointing, but this does not obscure the fact that all ten are positive.
Furthermore, around 65% of S&P 500 stocks are above their 50-day moving average, a well-regarded gauge of near-term momentum. Slicing the data yet another way reveals eight out of the 11 GICS sectors are positive YTD. And finally, US small-caps are significantly outperforming large-caps this year, a good sign of a participatory market and economic strength. The Russell 2000 is up 11.2% on a total return basis YTD.
On Market-Cap Weighting
The heavy influence of FAANGM stocks on “market” performance is due to the prevalance of market-cap weighting, or the practice of giving higher importantance to larger stocks. In 1957, S&P introduced market-cap weighting as an improvement over price-weighting (which merely gives higher importance to stocks with a higher nominal share price). The goal here was to better approximate the general return across the total universe of investors. Cap-weighting certainly serves its purpose from an aggregation standpoint, but the methodology is not without its drawbacks. Perhaps foremost, it overweighs recent outperformance, leading to owning more of a stock as it increases in price; in essence, buying high and selling low.
Empirically, this is inconsistent with how many investors build diversified and balanced portfolios. For example, we submit that many investors wishing to own Amazon and Procter & Gamble would seek to own/establish similarly-sized positions; however, a “passive” investor in the S&P 500 is making a subconscious decision to own over 4x as much AAPL as PG. This disconnect can make market-cap gauges an imperfect way to measure performance. Remember: The goal of investing is not to beat a theoretical benchmark, but to provide for one’s financial stability and peace of mind. We urge advisors and investors to measure performance through the lens of progress toward long-term goals.
Returns for a cap-weighted index (particularly large-cap) nearly always will be driven by a handful of stocks. The outperformance of FAANGM stocks is fortuitous, as they are larger weights in the index. But even after this run, they are still within historical precedent as far as importance. As we can see in the chart to the left, the largest five members of the S&P 500 by weight have never dipped below 10% of the index, and historically have been much higher at other times. When a handful of companies are responsible for what seems like an outsized effect on the performance of a cap-weighted index, this is a feature and not a bug.
Tech Bubble 2.0?
Given heavy FAANGM news flow and strong multi-year runs for the individual stocks, many investors are likely to draw parallels to the technology bubble of the late-1990’s. For pundits, it is an easy narrative. While comparisons to the tech bubble will persist, we believe some distinctions are worth making. Net, we believe today’s market is on a much healthier footing than the ultimately precarious highs made near the turn of this century.
Currently, the technology sector weighting in the S&P 500 is ~26%, well below its March 2000 peak of ~35%. Though technology is indeed the largest weighting in the S&P, and is currently a bit larger than its historical average, we are by no means concentrated to the extent we were in 2000. One could also argue that the rising importance of tech merely reflects the evolution of the US economy.
Furthermore, FAANGM momentum is not necessarily tech momentum. Once sector realignment takes place this fall (to be tackled in a future Deep Dive), the group will consist of three Communication Services stocks (Netflix, Alphabet and Facebook), one Consumer Discretionary (Amazon), and two Technology names (Microsoft and Apple). In reality, this realignment is semantics; these companies, while innovative and to some extent dominant, are in varied businesses. In our view, even the FAANGM moniker itself supports this, as the original shorthand was “FANG.” As other businesses have evolved and grown (in this case, Apple and Microsoft), they have been added to keep the narrative intact…we wonder what the market would think about a new TFAANGM (the “T” is silent), so we could look at Tesla too!
Finally, we would be remiss not to mention valuation. At its top in 2000, the tech sector forward P/E peaked above 45x vs. ~25x for the S&P 500. That valuation discrepancy today is nonexistent. Tech’s forward multiple is 18.4x, slightly above the S&P 500 at 16.7x. This is not to say the market is not overvalued; however, in our view it does support a thesis that we are not in a market environment that is unduly optimistic toward just one particular theme or sector.
In short, our view is that “disruptive” or “innovative” are more reasonable shared attributes of these firms. There may well be reasons to group them, but in our view they better depict a new age of oligopolies (Netflix probably excluded) than they do a fresh round of hope-based, everyone’s-a-winner hysteria that characterized the internet-fueled boom of the late 90s.
FAANGM Moving Forward
Having made our case that FAANGM emergence is not Tech Bubble 2.0, we are compelled to mention a universal and secular concern: Regulation. As FAANGM stocks continue to grow their economic footprint, the calls for stronger regulation will likely increase. Facebook gave us a preview, highlighted by congressional hearings surrounding the Cambridge Analytica scandal, and recently Alphabet was served a ~$5B fine from EU regulators relating to anti-competitive practices tied to its Android operating system.
Alphabet and Facebook control ~60% of the digital ad market; Alphabet alone controls ~80% of internet search revenues. Cloud infrastructure is another area of high FAANGM concentration, where Amazon, Microsoft and Alphabet account for over 50% market share. Amazon continues to shake up retail, and seems intent on “fixing” the consumer experience across other sectors (e.g., the recent acquisition of an online pharmacy). Amazon has shown the ability to move markets by merely announcing interest in entering a new business. Apple, Amazon and Alphabet all have ever-expanding ecosystems that span industries and create captive consumers. Finally, these concerns speak nothing of a (potential) sharpened taxation focus, as FAANGM businesses pay notoriously low tax rates.
In our view, the prevailing FAANGM narrative is not Tech Bubble 2.0, though these stocks have certainly been important to recent market performance. FAANGM stocks are market leaders, comprised of both innovative and economically important companies, but to call this market narrow would be simply misleading. We believe the US market remains broad-based and healthy. Three out of every five US equities are positive on the year, and stocks across the market-cap spectrum have performed well. FAANGM may be a catchy headline, but it is certainly not the full story in US stocks.
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