“I have a high conviction that before the end of this year the FAANGs will be unravelling, as the structural arguments supporting these bubbles turn to cyclical sand”, Albert Edwards writes, kicking off a doozy of a new note called “FAANG bubble is nonsense on stilts. Embrace the coming crash”.
I often speak of “vintage Edwards” when describing particularly colorful passages from Albert’s notes. That description applies to the entirety of his latest, which is a tour de force in bearish bubble-bursting balderdash.
The recent pro-cyclical rotation notwithstanding, the resilience of US equities in the face of the worst economic downturn in at least a century has been in no small part attributable to a handful of big-cap tech titans.
Often we focus on market concentration – and for good reason. The top five names now comprise more than 20% of the S&P 500’s market cap, a higher figure than that seen during the dot-com bubble.
This is part and parcel of what Howard Marks described as a “perpetual motion machine”, aided and abetted by passive flows to products that track cap-weighted indices dominated by the same names. This is accelerated by “smart beta” vehicles and factor-based products, many of which hold the same handful of stocks which at various intervals have become synonymous with multiple factors at once, leading to “factor crowding”.
Read the latest: Robinhood, Mega-Cap Mania, And Peak Perpetual Motion
Edwards touches on this in the context of his long-standing contention that what most market participants believe are “growth” stocks will be exposed as cyclicals in a downturn.
To be sure, Albert is not the only analyst to suggest as much. Indeed, back in the summer of 2017, as part of an infamous note which triggered a brief selloff in tech, Goldman suggested that factor crowding may mask the cyclical nature of some popular stocks. Here are two key excerpts from that now three-year-old Goldman note:
While FANG has dominated investor focus, the nature of the acronym has expanded more broadly to encompass mega-cap tech. Indeed, the bigger story in our view is FAAMG – Facebook, Amazon, Apple, Microsoft and Alphabet – a group of five stocks which have been the key drivers of both the SPX & NDX returns. This outperformance, driven by secular growth and the death of the reflation narrative, has created positioning extremes, factor crowding and difficult-to-decipher risk narratives (e.g. FAAMG’s realized volatility is now below that of Staples and Utilities).
Is FAAMG the New Staples? Remember “Min Vol” – its Back… FAAMG stocks are cyclical growth stocks that have increasingly been treated like stable Staples with a similarly negative correlation to interest rates and even lower realized volatility. These “min vol” characteristics could draw incremental flow into the stocks but can just as easily reverse.
Those passages could have been written yesterday and they’d be equally applicable.
Edwards recaps how this played out during the dot-com bust. To wit, from his Thursday note:
The 2001 recession exposed the tech sector as heavy with cyclical stocks masquerading as growth stocks. It was an easy mistake to make as the economic cycle had gone on for so long, and so many of the stocks were so young that they had never experienced a recession. Analysts could not easily distinguish the cyclical tech stocks from the growth tech stocks, especially as they too were intoxicated by ample Fed liquidity and a New Era frenzy… When the 2001 recession unfolded, many tech stocks suffered a totally unexpected fall in profits. These were not growth stocks at all and shouldn’t have been on 40x+ PEs. These were in reality cyclical stocks trading on peak multiples on peak cyclical earnings when they should have been trading on top of the cycle, single-digit PEs. And when the market discovered these stocks were on the wrong PE ratings based on the wrong forward earnings, the Nasdaq bubble collapsed.
This time, though, the Nasdaq bubble didn’t collapse.
Instead, it inflated to heretofore unseen proportions in the lead up to the pandemic (at least on some metrics), then deflated a bit, and then promptly reflated, especially relative to small-caps, although the NDX/Russell 2000 ratio is now chopping around as the market tries to decipher whether this rotation is for real.
Albert wonders if perhaps stocks can just keep going up forever given the setup.
“My expectation of a similar fate for tech in this recession has been proved wholly wrong. To be honest, I have been left scratching my head”, he writes, before joking that “I feel I am suffering from that awful psychological affliction virtually unknown on the sell-side – namely self-doubt!”
After all, if the perpetual motion machine dynamic continues to mean that large-cap indices are essentially just “FAAMG plus some other stuff”, and those names benefit not just from expected shifts in consumer behavior and social interaction following the pandemic, but also from the broader macro trend wherein, all efforts to stimulate aside, bond yields continue to trend lower as policymakers are unable to generate robust, sustainable growth/inflation outcomes, well then “why can’t the S&P carry on rising in line with falling bond yields?”, Albert asks.
“Maybe ever higher PEs are consistent with low bond yields after all if the market is stuffed full of growth sector bond proxies?”, he goes on to wonder.
The chart on the right above shows that tech profits are holding up better than the rest of the market. Indeed, looking ahead, that’s really the only place where anyone expects to find growth.
Edwards drives this point home using some charts from Gerard Minack, who combines FAANG with FAAMG to get FAAANM (Facebook, Apple, Amazon, Alphabet, Netflix and Microsoft).
Consider that, as Albert recounts, “the massive outperformance of the S&P versus the MSCI rest of the world is almost entirely attributable to the FAAANM”.
Indeed, the S&P494 (as Albert quips, in a riff on my “FAAMG plus some other stuff” characterization) is essentially no different performance wise than global equities more broadly.
Edwards calls this “as significant as it is shocking”.
Equally shocking are the charts below, also from Minack, which illustrate the extent to which FAAANM is almost solely responsible for sales and profits outperformance in US stocks. That is, when you strip those out, corporate America hasn’t done much better than “corporate world”, if you will.
Clearly, this leaves the US equity market vulnerable to a scenario where those stocks take a significant hit due to (oh, I don’t know) executive action that opens some of them up to ambulance-chasing lawyers or antitrust proceedings both at the state and federal levels.
Of course, a more conventional way for the bubble in these stocks to burst would be for the type of pro-cyclical rotation which has dominated the reopening trade over the past several sessions to become entrenched, leading to outperformance from cyclicals and the like.
And yet, that doesn’t match up with Edwards’s expectation for bond yields to keep falling. Instead, Albert is sticking with the view that the current recession will lay bare the cyclical nature of these high-fliers.
“I personally suspect that this recession will ultimately expose these and the tech sector to be far more cyclical than appreciated”, he says, noting that in that scenario, “it will be difficult… to maintain their 32x forward PE”.
You can come to your own conclusions there, and Albert draws a parallel with commodities and EM in 2008, but I think the better way to close is with another quote from Edwards’s Thursday missive which I’m sure will resonate with the Fed critics among you (of which there are many). To wit:
We are now only 10% from February’s all-time high, and with the US unemployment rate heading towards 20%, one might ask: At what point does the stark disconnect between Wall Street and Main Street become a political embarrassment for the Fed? Maybe never.