Positive performance for U.S. equity markets in 2015 has been dominated by four stocks now known by the acronym FANG – Facebook Inc., Amazon.com Inc., Netflix Inc. and Google Inc. (even though Google changed its name holding company name to Alphabet Inc.). For investors, this is a disquieting reminder of the late 1990s, when the Four Horsemen – Cisco Systems Inc., Dell Inc., Intel Corp. and Microsoft Corp. – drove markets first to lofty heights, and then off a cliff.
The problem, then and now, is market breadth – the percentage of stocks showing strong performance. A market is considered healthier, with more dependable upside, when a larger number of stocks represent strong earnings growth and helping drive benchmarks higher. In periods where earnings growth is harder to find, investor assets gravitate to the rare stocks that do have rising profits.
Investors clearly moved toward FANG stocks in 2015. The chart below compares the value of $10,000 invested in the S&P 500 to a portfolio consisting of a $2,500 investment in each of Facebook, Amazon, Google (now Alphabet) and Netflix. The investment in the benchmark would have lost $259 or 2.6 per cent. The FANG portfolio would have generated a gain of $8,250 or 82.5 per cent.
In 2015, the FANG stocks added 32 positive points to an S&P 500 index that is down more than 60 points for the year. Amazon on its own contributed 24.5 per cent of index upside, according to Bloomberg data. It's safe to say that without these stocks, U.S. market returns would have been far worse in the past year.
In a narrow market dominated by a few winning stocks, historically the market leaders become extremely expensive in valuation terms. Benchmark performance becomes dependent on a small number of highly expensive stocks and this makes rallies fragile – if any of them falter, the benchmark suffers significantly.
Just like the Four Horsemen in the late 1990s, FANG stocks are now getting prohibitively expensive. Alphabet (the former Google) is the outlier with an almost-reasonable price earnings ratio of 35.7 times – that is only twice the S&P 500 average of 18.0. The rest of the valuation levels are in the stratosphere, headlined by Amazon's 966.7 times trailing profits. Netflix is trading at 312 times earnings and Facebook current stock price is 105 times earnings.
Market tops are notoriously difficult to predict and it's entirely possible that FANG stocks will continue to drive markets through 2016 despite lofty valuations. The investment risks, however, are clearly climbing as the narrow market trend continues.
Ideally, sectors beyond technology will arise to challenge to challenge the FANGs for profit growth and market leadership. Until that happens, investors should protect portfolios against significant market volatility.
Follow Scott Barlow on Twitter @SBarlow_ROB.