Watch Out For The FAANGsSubmitted by WWA Planning & Investments on August 19th, 2020
Last week I wrote about the idea that a bubble might be forming in the stock market. This week I’d like to delve into some of the reasons I’m concerned.
Let’s begin with some basics. Most often, when people talk about the stock market, they’re referring to an index known as the Standard & Poor’s 500. The S&P 500 is a collection of 500 large company stocks which is updated annually. Using this abbreviated view of the market, investors can focus on 500 stocks instead of tracking several thousand. While this approach is intended to make things simpler, it may or may not always make them clearer. For more about indexes, you might want to refer to this article I wrote a few years ago.
By design, the largest companies among the 500 are given the most weight in the reported results. All the headlines I read say that ‘markets are doing well’ so far this year but please consider the chart below. It presents six large tech companies (known as the FAANG stocks) separately from the other 494 index members. As you can see, Facebook, Amazon, Apple, Netflix, Google (plus Microsoft) have done extremely well, accounting for more than 100% of the gains in the index. The remaining stocks have actually lost value through the end of the second quarter.
As I said last week, much of this performance is driven by the Fear Of Missing Out: the higher the index moves, the greater the fear of small investors that they’ll be left behind if they don’t invest. Is that good or bad? I’d say that knowing what you’re investing in and why you’re doing so is a more useful approach than simply jumping into the market based on headlines.
Since 1926, stocks with a value tilt (those with a lower price-to-earnings ratio than average) have outperformed growth companies (the opposite) by about 4.5% annually. However, since 2016, growth stocks have been doing exceptionally well, outperforming value by a significant margin: +76% to +2%. Perhaps you’ve guessed that the six stocks I’ve mentioned are all growth companies.
When I began studying financial planning, I learned that diversification was important to minimize risk and that owning a range of investments tends to offer protection against downturns. However, there is a cost: a diversified portfolio doesn’t perform as well as an investment in a single class that’s doing unusually well. That said, I still believe in the concept of diversification. Here’s a photo that recently joined the collection of financial advice that covers our conference room walls. (You can read about the other quotes at articles and sayings.)
Due to the overweighting of the FAANG stocks in the S&P 500, index investors have put virtually all their eggs in one basket. As long as these six huge growth companies continue to dominate, those investors will be rewarded. If and when the ninety-plus year bias toward smaller and value stocks returns, I’m afraid they will learn an uncomfortable lesson – making money in the market may not be as easy as the headlines suggest. We believe it’s important to remain invested but we continue to do so strategically.
There’s a quote from our collection that applies here. Sir John Templeton said, “The most dangerous words in the English language are ‘This time it’s different.’ Perhaps investors should be asking whether this time really is different or if more typical market performance is likely to return at some point.
Am I worrying about nothing? It’s certainly possible. With interest rates being deliberately held at extremely low levels, investors seem more likely to choose stocks over CDs and other bonds until rates improve. Also, a huge amount of money remains on the sidelines and these funds often find their way into the stock market. Either fact might drive ‘the market’ higher.
I’m not the first to write about either FOMO or the FAANG stocks but I hope I’ve been able to add a bit of clarity to your understanding of how markets work. Jalene, Andy and I are here to try to answer further questions.