Ok, so over the past couple of days, the regulatory worries that plagued big-cap tech and helped catalyze the bloodbath that unfolded in the sector late last month have given way to earnings optimism, and not a moment too soon.
Market participants have a lot on their plate right now and as we and others have variously argued, just about the last thing anyone needs amid geopolitical tension, tariff jitters and domestic political turmoil in the U.S., is for tech to suddenly roll over.
FAAMG is where the growth is:
And as you’re acutely aware, it’s also where the outperformance is concentrated:
Here’s Goldman’s Ben Snider reminding you about just how lopsided this is getting:
Over the last five years, fast sales growth and high profit margins have driven the Technology sector to contribute 73% of S&P 500 margin expansion and one-third of EPS growth. The strong fundamentals have led to remarkable outperformance: Since the start of 2017 the Tech sector has contributed 43% of the total S&P 500 return, with the “FANG” stocks alone accounting for 12% of the market return.
While there were already privacy/monopoly questions swirling around big-cap tech and while social media was already under scrutiny for the extent to which the most popular platforms were effectively hijacked by a foreign government in the lead up to the 2016 election, the Cambridge Analytica fiasco was the straw that broke the camel’s back.
One of the worries here is that crowding in the space could exacerbate a drawdown if regulatory worries are borne out or otherwise prove to be something more than a “this news cycle” phenomenon (if you will).
As we detailed earlier this week in “‘Herd’ On The Street: Crowded Trades Get Slaughtered As World’s Most-Followed ‘Strategist’ Proven Right“, everyone is in these names – if not by choice, then by sheer necessity, as hedge funds simply can’t afford to sit idly by as their “all star” managers are outperformed by QQQ.
BofAML’s most recent Global Fund Manager surveys have consistently identified “Long FAANG + BAT” as the most crowded trade…
…and a snapshot of the most popular hedge fund positions from December betrays the extent which the herd mentality has everyone sitting in the same names:
With flows into and out of QQQ starting to resemble “hot money” (i.e., folks are predisposed to pulling everything out at the drop of a hat), it seems entirely possible that these crowded tech positions could suffer mightily in the event the regulatory concerns don’t abate. Here’s more on that from the above-mentioned Ben Snider:
The Tech sector’s widespread popularity raises the risk facing portfolio managers. At the start of 2018 Tech stocks accounted for 26% of large-cap mutual fund portfolios, equating to a 235bp overweight relative to benchmarks, the largest among sectors. Hedge fund filings show a similar preference among levered investors, with 24% net exposure to Technology. Passive investors are also exposed to the risk of a downturn given the Tech sector’s large market weight, at 25% of S&P 500 market cap. During the last 50 years, only the Energy sector in the early 1980s (26% weight), Tech in the late 1990s (35%), and the Financials sector in the mid-2000s (22%) have similarly exceeded 20% of S&P 500 index weight. Forebodingly, those three episodes each culminated in an absolute price decline in excess of 50% for the high-flying sector and underperformance relative to the S&P 500 of roughly 30pp. Arithmetically, the Tech sector’s large weight could easily drag down the broad market if investors cut exposures without finding an appealing place to reallocate.
Fortunately, Facebook and Amazon delivered this week and all is temporarily “right” in the world. That is until the next headline about stolen social security numbers or the next Gundlach short call or the next Trump Amazon tweet.
So with all of that said, what’s the outlook for tech regulation? How big of a concern is this? Well, that’s the subject of Goldman’s latest “Top Of Mind” note. As a reminder, these are basically expansive takes on whatever the market topic du jour happens to be. They combine interviews with Goldman’s own employees and also with outside sources in an effort to provide a balanced and comprehensive assessment on whatever seems to be the most important question on market participants’ minds (hence “Top of Mind”).
This installment includes the following helpful “roadmap to tech regulation”:
And it also includes an interview with Doug Schwartz, a partner at CGCN Group, former Chief of Staff to the Senate Republican Conference, working on legislative and political strategy, and former senior advisor to Senator John Thune of South Dakota.
In the interview, Schwartz argues that while Congress isn’t likely to regulate tech imminently, action could come from the Federal Trade Commission. We present excerpts from his interview below.
Allison Nathan: Broadly speaking, how has the technology industry traditionally been regulated in Washington? Have policymakers/regulators been rethinking their approach?
Doug Schwartz: By and large, Congress has pursued a regulatory environment that is not overly burdensome and seeks to foster innovation in the tech space. It’s too early to say whether this “light-touch” approach will ultimately change in light of the enhanced focus on data privacy, but there is certainly an unprecedented level of scrutiny and awareness in Washington of technology companies. I expect to see plenty of continued attention from Congress, with more hearings this year and heightened engagement by members. Whether that translates into actual legislation that is signed into law is very much an open question at this early stage of the debate. Crafting a bill on something like data privacy is a complex undertaking involving many stakeholders, and there simply is not a clear consensus in Congress right now on what should be done.
Allison Nathan: Where does tech find support in Washington? Is there a specific party that typically aligns with the sector’s interests?
Doug Schwartz: Tech seems to be politically “homeless” right now—facing tough questions from critics on both sides of the aisle. On the Republican side, while many lawmakers have typically backed the interests of the tech industry on bottomline issues related to taxation and regulation, the tech industry is often viewed as not being particularly friendly toward Republicans. And of course, Republicans have had serious concerns about anti-conservative bias and censorship of conservative viewpoints on social media platforms. So Republicans won’t necessarily fall on their sword to defend the industry today.
Democrats, on the other hand, have their own reasons to be skeptical: not only the recent revelations about privacy practices, but also the perception that parts of the industry played a role in President Trump’s victory in the 2016 election. So the Democrats are not all that interested in carrying water for tech companies, either.
Allison Nathan: Is Congress moving forward with any tech-related legislation? What’s the likelihood of increased regulation in the near term?
Doug Schwartz: The most likely near-term changes actually aren’t directly related to the data privacy concerns that have been in focus, or to the notion of breaking up the big tech companies. Instead, the more immediate issue is reform to the Committee on Foreign Investment in the US (CFIUS), which would increase the US government’s ability to block foreign acquisitions and investments in the US, many of which are tech-related. CFIUS reform has bipartisan support in the Senate and White House approval, so it has the best chance of any tech-related legislation on the table to get enacted this year.
As far as other legislation in the pipeline, there is some support for the Honest Ads Act, which would require more transparency for online political advertising. It could pass this year, but I wouldn’t consider it likely. And any privacy-related legislation is very likely to get pushed back. In general, I would be surprised to see substantial legislation on tech-related issues—perhaps with the exception of CIFIUS reform—this year. With the midterm election looming in November, the legislative schedule is becoming increasingly compressed, and there won’t be much time to get things done in Washington.
That being said—as I mentioned—an even bigger issue is that policymakers don’t yet know what they want to do on data privacy. There is no off-the-shelf bill ready to go. If Facebook or Twitter were to ask what they could do to make Congress happy, they’d come away with a long and varied list from members within each party. Members are still in the early stages of gathering information, holding hearings, and demanding more industry engagement. It will take some time before they can approach something remotely resembling consensus within their own parties, let alone a bipartisan consensus. In the meantime, more individual pieces of legislation will likely be announced as members begin to “mark their territory” and lay the groundwork for future leadership on these issues. But actual action will be a story for 2019 and beyond.
Allison Nathan: Do you believe the recent revelations about Cambridge Analytica—and Zuckerberg’s subsequent testimony—represent a watershed moment, in which Washington more fully turns its attention to Silicon Valley? Or will the issue of tech regulation fade?
Doug Schwartz: I’m not sure I’d call the recent developments a watershed moment, but I don’t think the genie will be put back in the bottle, either. From a congressional perspective, tech is now being treated more like other industries, which have long been subjected to greater oversight, CEO questioning, and congressional testimony. That’s a new development we probably won’t see reversed.
However, past experience suggests that the interest in data privacy may peter out. For example, Congress has not acted on data protection even after several other large data breaches that touched many constituents. Whether data privacy on social media and in advertising proves to be more salient remains to be seen. I think that will depend to some extent on media coverage. If we see a steady drumbeat of Cambridge Analytica-style revelations that captivate voters and politicians, Congress will continue to respond. But in the absence of more high profile controversies, this issue is not a lock to continue to take up a lot of political oxygen, given the many other issues on Washington’s agenda.
Allison Nathan: What are the prospects for regulatory action outside of Congress, either by the Federal Trade Commission (FTC) or others?
Doug Schwartz: In the near term, the Federal Trade Commission (FTC) certainly poses a greater regulatory threat than Congress. The FTC is much better positioned to move quickly, and it has the power to dole out substantial fines. However, industry-wide regulation does not fall under the FTC’s purview. Instead, the FTC handles case-by-case investigations. For example, the FTC has an ongoing consent decree with Facebook going back to 2011 and has indicated plans to investigate Facebook’s compliance with that decree. A new slate of federal trade commissioners is set to receive Senate confirmation very soon. Once the new commissioners are in place, they likely will want to put their stamp on the data privacy issue or at least look into it carefully. Whether that leads to some action or penalty will be key to watch.