Zeller Kern’s Investment Monitor
Is the FAANG Getting a Little Long in the Tooth?
March 21, 2018
By Steve Zeller
In the last issue of the Investment Monitor, we discussed the possibility of the current nine year bull market reaching its final high. If that is the case, the high was realized on January 26th with the S&P 500 closing at 2,872.87. However, the past few weeks have produced a choppy sideways pattern for the market, and outside of the NASDAQ and FAANG territory, the major indexes have posted rather uneventful performance numbers. Year-to-date, as of the market close on Friday, the Dow Jones Industrial Average is up 1.47%, S&P 500 is up 3.38%, and the NYSE Composite is down -0.70%. The NASDAQ is the index that is carrying the weight, and is up 8.38%.
The NASDAQ may become a source of future volatility, as tech stocks have made a massive run up that is reminiscent of the dot com era during the 1999-2000 period. The market has become extremely concentrated. The FAANG stocks, being Facebook, Amazon, Apple, Netflix, and Google, have grown by more than 40% in the past year to a total market cap of $3 trillion. As a result, these 5 stocks account for more than 25% of the NASDAQ Composite. As it stands, Apple’s market cap is now around $900 billion, and Amazon’s market cap is at $760 billion. We shall see which one of these behemoths reach a $1 trillion in market cap. Although, many investors have benefited from the rise in the stock prices of these companies, they are also a potential for creating a serious downturn. A few of these stocks have price to earnings multiples that are just sky high. For example, Amazon has a forward P/E ratio of around 190X, and a current P/E ratio of around 250X. Netflix’s current P/E ratio is at 250X, according to Bigcharts.com. To put this into perspective, this means that an investor would invest $190 to receive $1 of Amazon’s earnings.
The first member of the “FAANG”, Facebook, has shown signs of weakness in its stock price, as it finds itself dealing with systemic problems of data breaches. Apparently, it was reported over the weekend that there was a data leak that exposed about 50 million user accounts, which raises the risk of regulatory controls for the “social media platform”, and would theoretically hinder advertising revenue.
The market appears to be in a sideways pattern and we will have to see as to whether we will experience significant weakness going forward or if the market will gain some more upward momentum. So far, the source of the push upward has been from the mania of the FAANG stocks.
The bond market has been struggling. Year-to-date, most major U.S. bond indexes are down in single digits, with the Morningstar U.S. Core Bond Index down -2.04%, and the U.S. Long Core Bond Index down -4.19%. The risk moving forward, for the bond market, is mounting in our view. Bond yields are still at historically low levels. But, pressure for bond yields to rise appears to be mounting. There are a few good articles on Wolfstreet.com that discuss the trends for the bond market.
For one thing, yields for short term Three-Month Treasury bills have risen notably off of its record lows printed in October of 2015, when the Three-Month Treasury was at 0%. Fast-forward to last Friday, and the Yield for the Three-Year Treasury was at 1.78%, the highest level since August 19th 2008. (Reference Article: “What’s Going on in the Treasury Market?”)
The Two-Year Treasury yield has risen to 2.31% as of last Friday, which is the highest since August 29th of 2008. The yields on the short end of the Bond market, i.e. the Three-Month Treasury and the Two-Year Treasury, historically, react faster to rate hikes than the 10-Year Treasury. That being said, the yield on the 10-Year Treasury closed at 2.85%, as of last Friday.
Furthermore, the Fed raised rates four times since December of 2016, and many are expecting that the Fed will likely raise rates three to four times this year. The area that has yet to follow through with some serious weakness and decline is Junk Bonds. Although the performance of the Junk Bond Index has been waning, the ICE BofA ML U.S. High Yield Bond Index is only down -0.65%, year-to-date, according to Morningstar.com.
So, the trends for the bond market appear to be that of rising yields. The historical low for yields in the bond market, which occurred approximately 19 months ago (Referencing the 10-Year Treasury), has experienced a reversing trend, and the yield on the U.S. 10-Year Treasury has already climbed over 120%, from 1.32% on July 6th of 2016, to 2.96% recorded last month. Although yields for the 10-year Treasury have retreated down to around 2.85%, we expect yields to trend higher longer term.
In the investment-grade arena, Corporate Bonds are trading more parallel with U.S. Treasuries of equivalent maturities. As measured by the ICE BofA ML U.S. Corporate AA Effective Yield Index, the average yield of AA-rated bonds has risen to 3.27%, According to another recent article on Wolfstreet.com. Even though these are still historically low yields, they are rising, and the cost of capital is rising for these companies, as a result.
As we have suggested to our readers in the past, keep your eyes on the bond market. Risk is relatively high, investors are very complacent, the debt load has mounted to astronomical levels, and yields for bonds are in a rising trend. World-wide debt has climbed to $230 trillion, by some estimates, fueled largely by the monetary policies of the central banks, driving down short-term rates, and purchasing assets, in order to make borrowing more attractive. But now, that appears to be reversing, and the likelihood that the bond market could disrupt the climb of asset prices may be a reality.
Speaking of the Fed, Chairman Powell will oversee his first meeting, where the expectation is for the Fed to move rates higher. As we mentioned earlier, the Fed is planning on raising rates three to four times this year. If they follow through, we’ll have to see what kind of impact it makes on things.
The other hot issue is the potential for trade wars as a result of the Administration issuing tariffs, on countries it views as engaging in unfair trade practices, primarily with steel and aluminum. To potentially make matters worse, there are rumors that the Trump Administration plans to administer even more tariffs on China. They are moving to punish China for its intellectual property theft, including international property infringements such as counterfeiting. The administration would impose tariffs on a large variety of products, including tech products and consumer goods. If this is true, it would likely get us into a trade war.
All of these items may present a feeling of overall uncertainty and everything may be hanging on the Fed statement and Chairman Powell’s conference call on Wednesday at 2:30 PM Eastern time. For the balance of the week, we will see Leading Indicators on Thursday, Kansas City Manufacturing Index, Jobless Claims, and FHFA House Price Index. On Friday, Durable Goods and New Home Sales will be released with expectations that home sales will continue to soften.
In the end, most of these economic releases will have minimal impact as folks will be talking about the outcome of the FOMC meeting and actions taken. A failure to raise rates would send the signal that indeed the economy is weakening. So, as usual, the Fed’s transparency appears to have painted them into a corner once again.
This week may be key to deciphering the next several months, should the Fed raise rates this week and market participants get a better sense for what Chairman Powell is likely to do moving forward. As we have discussed the bond market, we will be watching the yield curve very closely for clues to what is likely to occur as we move forward.
Zeller Kern Investment Committee