Are the FAANG’s propping up the S&P 500?
Which way for the US market?
July saw equities markets rise higher, with the US a beneficiary once again, even discounting the currency kicker from a rising dollar. Despite political and trade headwinds, the US economy is performing well. Equity markets are usually sanguine about life and content to remain optimistic until the evidence against them is incontrovertible. The bond market, whose investors’ greatest fear is the loss of capital, takes a very different line. That difference in outlook is becoming increasingly stark in the US. We can see this in three key indicators.
1. A flatter Yield Curve
We have been regularly highlighting the flattening of the US Treasury yield curve over the course of this year. Longer term interest rates are normally meaningfully higher than short term rates, to compensate for added risk. Over the last 40 years, when the yield on 10 year Treasury Bonds is less than the 2 year yield, the US has seen a recession within the following two years. The risk of another ‘inverted yield curve’ is clear from the chart below. Yet in July the S&P 500 shrugged off this warning from the bond market yet again.
Source: St Louis FED, July 2018
2. Cash v Dividend Yields
For the first time since the Great Financial Crisis, US 3 month Treasury Bills, a proxy for cash, are yielding more than 2%. Rates have been pushed higher by the continued drive in the Federal Reserve’s “quantitative tightening” policy, urged on by President Trump. With the risk-free, proxy for cash yielding more than shares, the resilience of the equity market has to be questioned. Especially as its QE underpin has been removed. If an investor can get 2% without taking risk, there has to be a compelling case for moderately risk tolerant investors to move cash into equity market holdings.
Source: FT.com, July 2018
3. Credit spreads
Our third indicator is in the valuation of corporate debt. Over the past seven months we have seen credit spreads on Corporate Bonds (the additional interest demanded for risk above the coupon on a government bond) widen from a post Financial Crisis low. The implication is that bond investors are becoming less confident in their outlook, aware of the danger that high levels of leverage in US company balance sheets pose to profit and loss accounts – in a rising interest rate environment. As the S&P has ridden higher, US corporate bonds have fallen in value, and that gap cannot logically grow too wide. How can a company be growing more valuable if its debt needs to be discounted?
Source: FE Analytics, July 2018
Despite bouts of volatility, as we saw in the Spring, the S&P 500 has continued to storm higher. July was another particularly positive month, rising 3.7% in dollar terms. Equity investors have chosen to focus on strong economic growth and full employment, expecting this to drive earnings even higher. While the economy is in full swing, the danger of debt laden balance sheets seems arguably less of an issue. But it does look more complex when you look at the detail.
Cavities in the FAANG’s
Despite the S&P rising 6.5% this year, if you exclude the FAANG’s – Facebook, Apple, Amazon, Netflix, and Google – from the equation, the remaining “S&P 495” are standing at a collective loss of 0.7%. Many investors assume the dominance of these major technology companies will continue. They enjoy structural tail winds, first move advantages and have unique intellectual property to maintain their double digit earnings growth. But double digit growth is hard to maintain as the evidence of the past will show. The market had a reminder last month that not all FAANG’s are created equal when Facebook announced its results. Analysts rated the stock as a consensus buy, in unison with the market, where it was trading at all-time highs.
However, downbeat forecasts for growth and margins changed all that. The differences between forecast growth in the 40% range against 20% and from margins above 40% against 30%, have a huge impact on future earnings calculations. This lead to an intraday fall in Facebook’s shares of 20%, wiping out $118bn of shareholder value. When the picture changes, equity investors can adjust rapidly.
Resolving the paradox
Perhaps the debt and equity market are not giving us contradictory signals after all. Despite Trump’s tax cuts and sparkling earnings growth in the first quarter, the “S&P 495”, the index minus the FAANG’s, may be mirroring the concerns we see in the fixed income market. While the FAANG’s by themselves have produced remarkable returns for the overall index, whether they continue to pull the market higher is a key theme for the second half of 2018.
“The above article is intended to be a topical commentary and should not be construed as financial advice from either the author or Parmenion Capital Partners LLP. If a client wishes to obtain financial advice as to whether an investment is suitable for their needs, they should consult an authorised Financial Adviser. Past performance is not an indicator of future returns.”
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