A balanced diet is healthy but investors need strong FAANGs

A rotation into some cyclical stocks has lifted equity markets of late. But investor returns overall are still heavily reliant on a small basket of tech stocks with sky high valuations and any retreat from these names in a hurry could prompt a stock market rout.

Rotation has been the most important theme in equity markets since the start of November, when Pfizer and BioNTech released positive results for their Covid-19 vaccine.

Further good vaccine news raised hopes that the gloom of Covid-19 lockdowns will lift and the global economy will rocket in a bacchanalia of consumer spending.

That sent equity investors to reallocate funds from the high-growth tech names that have driven the market up for over two years to stocks which have been badly beaten up as a result of the pandemic.

That is a healthy shift but should this shift happen too quickly it could send equity markets tumbling.

Apple, Alphabet (Google), Amazon, Facebook and Microsoft make up over 20{b5d304c96e94113bdfc523ff4218a1efff4746200bdb9eeb3214a56a1302f2e4} of the S&P 500 because of their huge market capitalisations. Netflix is another big tech stock and together with the first four, forms the famous FAANG acronym. Their outsized influence on performance will be even greater this month when Tesla joins the index.

Trillions of dollars from passive funds that benchmark the S&P 500 will accompany Tesla’s inclusion and the theory is these funds will spur its meteoric share price rise even higher; it is already up 559{b5d304c96e94113bdfc523ff4218a1efff4746200bdb9eeb3214a56a1302f2e4} this year.

A meteoric rise in equity valuations for these stocks this year has caused their earnings multiples to balloon given many of their revenues have been flat or slightly down for the year.

The only thing that is supporting these lofty valuations is the belief that they will keep rising in price.

So should the market actively turn to selling tech next year, based on fears of overvaluation? Or will an external catalyst, such as more rigorous regulation from new US president Joe Biden put buyers off? Any number of forces could drive investors away and in their wake, an ocean of passive money will follow, accentuating the effect.

Their weighting in the indices would pull stock markets down turning a sector-specific sell-off into a global retreat. This would transform what is predicted to be a dream year for equity capital markets issuance into a nightmare.

Several sources speaking to GlobalCapital over the last fortnight have highlighted sector rotation and the valuations of some of the mega-cap tech stocks as one of their biggest concerns heading into Christmas.

Perhaps the tech bubble will never burst and these equity giants will be forever spurred on to new heights by low interest rates, passive flows, retail investor enthusiasm and maybe even revenue growth.

But their earnings multiples look fragile and after two years of surging share prices, capital markets bankers and investors should certainly pause for thought when planning for 2021.

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