Friday, October 16th, 2020

FAANGs can bite you

Like most other professionals, investment analysts love complexity. It’s what makes them valuable – in their own eyes – if not everyone else’s. But sometimes, the important questions are very simple, almost frighteningly so. Right now, the only question that matters is whether the FAANGs can continue to outperform.

The Q3 earnings season has just started and these companies will publish all the financial information which investors could reasonably expect, but this may not provide any valuable insight. Most of our clients long ago abandoned any conventional valuation framework when assessing these companies and the level of uncertainty surrounding earnings forecasts and the future political, economic and fiscal regimes has never been so wide.

In these circumstances, we believe that simple technical and quantitative processes can help investors decide what to focus on. When it comes to the US FAANGs and their fellow travellers, there are two sector charts which give us cause for concern: the first is China Technology relative to the China index; the second is US Communications relative to the US index.

We have long argued that Chinese Technology’s relative performance is a lead indicator for the US Tech sector, so we republish a chart we have used before showing how the relative weight of Tech in China tends to crack before the US and then lead it lower. This time China, cracked in late July and is course for a downgrade to neutral sometime in November. We would expect the US sector to follow the same trajectory with a gap of about five weeks. As we noted, in our recent note (Party Like It’s 1999 – August 7th) the US Tech sector does not normally bottom out until it is well into underweight territory.

The second problematic chart is US Communications, which we have downgraded to neutral this week. The sector is dominated by Facebook and Google, two of the FAANGs, which are front and centre in the great policy debate about privacy, media bias and market dominance. We have no insight into which party is going to control which part of the US government apparatus or what they will be able to do when they get there. But we do know that both companies have dropped through important technical signals, which suggest that there is further downside. In addition to the politics, we suspect that investors may be starting to discount another more fundamental risk.

Depending on which forecast you believe, digital advertising will account for between 55-60% of total ad-spend in the US in 2020. Google and Facebook are already dominant in this category and are starting to face stiff competition from new entrants, including Amazon. There is a rising probability that their period of super-normal growth is coming to an end. There may be other revenue streams available to them, but they will be small in relation to their current turnover and may not be enough to prevent a material de-rating as we move into 2021. If Google were a sector on its own it would be rated underweight, with a high-conviction negative lead indicator. Facebook is just about to be downgraded to neutral, with a medium conviction, negative lead indicator. These are not signals normally associated with market leadership.

We have models for another 28 companies in the Tech sector, of which 12 are below their MAV, 13 above, and 3 in line. If we look at the level of our probability score, not the trend, 16 out of the 28 are below their level in late July, when we last wrote about the sector, and only 10 are above, with 2 the same. This suggests that the sector is heading for a downgrade.

Conclusion: We re-iterate our call to take profits in US Tech. Among the FAANGs, only Apple, and possibly Amazon, still look robust. Google has been downgraded twice, Microsoft once, and Facebook is just about to suffer its first. In the rest of the sector, there are individual companies which still look attractive, but the majority do not and their number is growing.

The fact that we are negative on Google and Facebook does not necessarily mean we should be negative on all the other FAANGs but we should at least ask the question. The most important signal we use is the probability of an individual stock outperforming the index on a risk-adjusted basis and how it relates to its own 26-week moving average.

Google broke down through its 26-week MAV in early August, while it was still overweight. Facebook did the same two weeks ago. Netflix did the same 5 weeks ago and Amazon did last week. Of the FAANGs, only Apple is still above its MAV, but Microsoft, the other trillion-dollar company dropped below its MAV in August and is now rated neutral.

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