After the S&P 500 advanced 7% in August, its best showing since 1986, investors have taken some profits in September. Given so much economic uncertainty caused by the path of the COVID-19 pandemic, some market volatility is to be expected.
However, what is concerning is the S&P 500’s outsize weighing of mega-cap Internet companies, only five of which now constitute a remarkable 26% of the index, up from 14% three years ago. These stocks are Facebook, Apple, Amazon, Microsoft, and Google parent Alphabet. Market analysts call these five the FAAMG, a slight variation on the acronym FAANG, substituting Microsoft for Netflix.
The FAAMG stocks have been on a tear this year, taking full advantage of 2020’s tech boom that has rewarded companies with healthy balance sheets and strong growth further boosted by remote working and learning during the pandemic. Valuations as measured by trailing twelve-month P/E ratios have expanded, with Facebook at 33x, Apple 35x, Amazon 119x, Microsoft 36x, and Google (Alphabet) 33x. September’s weakness has largely been caused by share price declines in just these five names, causing some to claim that we are in a stock market bubble akin to the Nifty Fifty of the 60s and 70s.
There do seem to be some parallels between today and that era. While never an official index, the Nifty Fifty was the name given to a group of growth stocks that performed very strongly year after year such that their valuations became unsustainable. By the early 70s, the P/E ratio for various household names such as Johnson & Johnson was 57x, McDonald’s 71x, Disney 71x, Avon Products 61x, and Polaroid 95x. Against a backdrop of rising interest rates, higher oil prices, and political uncertainty over Watergate, stocks entered a bear market in 1973. After initially holding up well, the Nifty Fifty stocks fell dramatically, as illustrated by Avon and Polaroid declining 86% and 91%, respectively, in 1974.
However, the valuation of the FAAMG stocks needs to be put in context with the rest of the stock market. According to FactSet’s Earnings Insight, S&P 500 earnings declined 32% in the second quarter as the economy was largely shut down. Weak earnings coupled with the market’s strong recovery since March lows has widened the S&P 500’s trailing twelve-month P/E ratio to 34x. When compared to the Nifty Fifty, the relative valuation of FAAMG stocks don’t look like much of a bubble, with the exception of Amazon.
Does this mean investors should ignore the other 495 stocks in the S&P 500 and just buy FAAMG stocks? Of course not! Diversification is one obvious reason, as September weakness has illustrated. Further, staying at home won’t remain the preferred lifestyle once COVID-19 risks recede, likely aided by a vaccine with so many promising candidates in late stage trials. Beaten down sectors, including Financials, Industrials, and Consumer Discretionary, will benefit more when consumers can confidently leave their homes. Therefore, we encourage investors to look for high quality companies broadly and not simply plow more money into the crowded FAAMG trade.
From the October 2020 issue of the Investor Advisory Service.