For Investors, Federal Reserve And Web 2.0 Are Poison Pills

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Includes: AAPL, AMZN, FB, P, TWTR
by: Kofi Bofah
Summary

Stocks have rebounded sharply out of the 2008 housing bust and credit crisis.

Federal Reserve policy has largely fueled the ongoing bull market rally. Much of the cheap money and speculative capital has flowed into Web 2.0 stocks.

Many investors may now be at risk for contagion due to a collapse in Web 2.0 valuations.

On January 30, 2015, the Dow Jones Industrial Average, S&P 500 and NASDAQ Composite closed out the trading session at 17,164.95, 1,994.99 and 4,635.24, respectively. In the aftermath of January 2015 volatility, each of the major averages headed into the month of February within 10% striking distance of all-time highs. In any event, the long-running and current bull market rally is a far cry from the depths of the 2008-2009 recession, when the Dow collapsed to 6,594.44.

Still, stock market valuations appear to have significantly outpaced underlying business performance. Real gross domestic product growth actually decelerated from 5% to 2.6% between calendar Q3 and Q4 2014. Perhaps most important is the fact that the Federal Reserve Board continues to literally flood financial markets with capital, with the intent of stabilizing the U.S. economy. Much of this speculative capital, however, has made its way into Web 2.0 stocks, in yet another case of "irrational exuberance." Going forward, smart diversification will be all-important for investors to avoid the fallout of another bust.

The Fed and Cheap Money

In 1913, an Act of Congress established the Federal Reserve System with the contradictory dual mandate of ushering the economy toward full employment while also preserving a stable price level. Last December, the Bureau of Labor Statistics pegged unemployment at 5.6%, while the Consumer Price Index dipped by 0.7%. Prominent members of the business community, however, have long disputed government-agency information. Even pollster Gallup has gone so far as to slam BLS unemployment statistics as "The Big Lie", because the data does not account for the underemployed and those who have given up looking for work. Alternatively, government inflation readings often neglect volatile food and energy prices.

As such, stock market bulls must be willing to debate the idea that Federal Reserve monetary policy and its effects are based upon misleading information. The cheap money has likely been inflating financial asset valuations rather than creating jobs and facilitating real growth. This top-heavy economic model cannot be sustained. In 2008, the real estate market ultimately crashed when working class incomes could no longer support sky-high average home sales prices above $300,000.

The Federal Reserve has kept its federal funds rate at zero for more than six years. In addition, the Fed also has committed to monthly purchases of $85 billion in Treasuries and agency-guaranteed mortgage-backed securities. As of January 29, 2015, the Federal Reserve balance sheet had ballooned to $4.6 trillion. For her part, freshly-minted Fed Chair. Janet Yellen has apparently telegraphed a move to drive interest rates higher, by the mid-point of 2015. A succession of rate hikes will likely divert capital away from an illusory Web 2.0 economy.

Web 2.0 Irrational Exuberance

Web 2.0 shares have emerged as a prime destination for Federal Reserve liquidity and speculative capital. As such, Web 2.0 stocks are mostly notable for outrageous stock market valuations relative to bottom line profits and the broader market. For example, Pandora (NYSE: P) is now worth $3 billion in terms of market capitalization, despite the fact that the Internet radio company has yet to turn any real profits as a publicly-traded corporation.

To date, Web 2.0 analysts have scoured monthly active user data as a means to track the growth of this business model. Ironically, Web 2.0 sites are often littered with automated bots, advertising spam and multiple accounts controlled by one central user. In 2013, The Wall Street Journal called attention to a Twitter (NYSE:TWTR) Robot Factory in Las Vegas, where Mr. Jim Vidmar managed 10,000 robots on behalf of nearly 50 clients. In doing so, a discrete Vidmar could trigger viral campaigns for private businesses and celebrities. Recent estimates for fake social media accounts have ranged from between 5% and 15% of the total amount in circulation.

Last December, Instagram eliminated roughly 30% of its own followers after completing a purge of fake accounts on the site. At that time, pop music sensation Justin Bieber also lost 3.5 million fake followers, or 15% of his Instagram total.

Facebook (NASDAQ:FB), Twitter and Amazon (NASDAQ:AMZN) have all largely failed to monetize their apparently massive user bases for real bottom line growth. Heading into 2014, the National Retail Federation ranked Amazon as the ninth-largest domestic retailer, with $44 billion in 2013 U.S. retail sales. For its 2014 fiscal year, however, Amazon racked up $241 million in losses upon $89 billion in net sales. The prior year, Amazon posted $74.5 billion in revenue and $274 million in net income. In any event, Wall Street traders have applied a wildly expensive $168 billion market capitalization price tag to Amazon.

The Bottom Line

Conservative investors should consider immediately liquidating out of pure play Web 2.0 positions. A great majority of Web 2.0 stocks feature non-defined price-to-earnings ratios due to a lack of real profits. For its part, Facebook shares now trade for 67 times earnings. Bulls, of course, would argue that a nominally high P/E is the proper price to pay to buy into a rapidly growing business. For his part, super-investor Peter Lynch may suggest that stocks featuring price-to-earnings-to-growth ratios of less than one are fairly valued. Facebook, however, is not likely to grow annual earnings by 67% into the near future.

Going forward, Web 2.0 stocks will emerge as the ultimate poison pill sabotaging broader market performance. Web 2.0 stocks are now priced to perfection and any earnings miss will precipitate severe losses within this subset of the technology sector. From there, Web 2.0 contagion will likely trigger a sharp 10% stock market correction within the next six months. At worst, an outright Web 2.0 bust will plunge the domestic economy into a recession. At that point, traders would then be grinding through 20% declines in both in the S&P 500 and Dow Jones Industrial Average.

A diversified portfolio, of course, may help conservative investors to manage these downside risks while also providing for upside potential. For tech exposure, Apple (NASDAQ:AAPL) has emerged as the best conduit into the Web 2.0 economy by supplying integrated hardware and software solutions to the marketplace. On December 27, 2012, Apple listed out $178 billion in cash and securities on its balance sheet, after generating a staggering $33.7 billion in Q2 2015 cash flow from operations. As an added bonus, Apple has pledged to return a total of $130 billion back to shareholders, through buybacks and dividends, by the end of 2015.

Disclosure: The author is long AAPL. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.