Living In A 'FANTASY' World

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by: The Heisenberg

Summary

If you needed further evidence to support the contention that we're flying ever closer to the sun, look no further than a new note from Citi touting "FANTASY" stocks.

The rationale for owning tech is now that things don't look "too outrageous" compared to the dot-com bubble.

Meanwhile, the Wall Street Journal finds that tech's share of one popular low volatility fund has risen more than three-fold in 12 months.

Quick, somebody pinch Citi, because the bank is having "dreams of the future."

I've talked a ton about tech over the past two weeks in the wake of Goldman's now (in)famous FANG/FAAMG note that threw the sector for a loop a couple of Fridays ago, but I'm going to have to talk about it some more, because Citi has just jumped the shark.

In a note dated Friday, the bank takes a crack at ... well, to be perfectly honest, I'm not entirely sure what they were taking a crack at, but the end result is a piece that's so full of punchlines that it would be impossible to document them all.

In short, Tobias Levkovich (that's the lead analyst on this one), outlines the outsized contribution of the "FANTASY" stocks (Facebook, Amazon, Nvidia, Tesla, Alphabet, Salesforce.com and Yahoo) to the market's YTD gains and then seems to try and justify absurd multiples by referencing "dreams":

Again, it's a rambling affair, but the way I read certain passages is that Citi seems to be trying to i) say that while 62X for "FANTASY" names seems stretched, it's fine because tech stocks (NASDAQ:QQQ) as a group aren't "outrageously priced," and ii) claim that because other stocks have moved up and/or down, the fact that this group has made up 23% of the S&P's YTD market cap gain isn't relevant.

See if you read it the same way (and do note the first bolded sentence):

Secular growth companies get extraordinary valuations as the dreams of the future make it harder to use traditional metrics and can affect the overall US equity market's P/E modestly.

There is only modest FANTASY distortion on valuation for the broader market, but the potential for a reversal of the sector rotation towards growth over the past few months exists. Figure 3 provides some insight into the valuation and market caps of the FANTASY names, recognizing Tesla is not part of the S&P 500 and that Alphabet is not as highly valued. Furthermore, the market cap weighted P/E of the FANTASY components runs at about 61.7x versus 21.6x for the overall index (using trailing four quarters EPS). The non-FANTASY included multiple might be closer to 20.8x, still not "cheap" per se but a bit less elevated than feared. More critically, tech stocks as a whole are not as outrageously priced versus levels seen back in 2000 (see Figure 4).

In our opinion, the powerful growth stories centered on software, social media and the spread of technology into all aspects of daily living have blossomed and captured investors' imaginations. The Street has become enamored with what we have dubbed the FANTASY stocks, which have added about $380 billion to the S&P 500's market cap (ex-Tesla) thus far this year, accounting for roughly 23% of the market cap gain of the index. But, it is not a fair statement since other names like Exxon have dropped meaningfully dragging down the index while Wynn Resorts has pulled it higher.

Again, it's not 100% clear to my why what Exxon and Wynn have done makes it "not fair" to mention the market cap gains of the FANTASY names, and further, I'm not sure the observation that "tech stocks as a whole are not as outrageously priced versus levels seen back in 2000," is all that comforting.

In the same vein, WSJ is out with an article that underscores the point Goldman was making earlier this month about how the relentless rally in certain tech names is causing them to become more correlated with volatility, thereby creating a danger that if volatility were to spike, they could get caught in the same kind of feedback loop that I've been warning could trigger deleveraging in volatility control funds.

Consider this from the Journal's piece:

Google, Apple, Microsoft, and other tech giants are more heavily represented than they were just a year ago in many so-called factor-based investing strategies. Many of these follow indexes that aim to beat or tamp down risk in the broader market, rather than mimic it, by systematically selecting stocks according to observed traits such as low volatility and momentum.

Technology now represents 11.3% of the $7 billion PowerShares S&P 500 Low Volatility Portfolio (NYSEARCA:SPLV) exchange-traded fund, which buys the least-volatile S&P 500 stocks. That compares with 2.9% a year ago, according to Invesco Ltd., the ETF's sponsor.

The development means investors holding a mix of seemingly disparate funds in the name of diversification could be surprised to find heavy concentrations in the same group of in-favor stocks, making them vulnerable in bouts of selling. Rules-based funds and strategies that gradually added tech stocks could sell them in a downturn, adding to price declines.

Not to put too fine a point on it, but that is precisely what Goldman was warning about and the language in the Journal's piece sounds a whole lot like what I said two Fridays ago. Specifically, here's how put it:

What's implicit (actually it's almost explicit) is that this setup isn't just dangerous because these stocks are shouldering a disproportionate share of the burden when it comes to sustaining the rally, but also because by becoming more highly correlated with volatility, they've effectively become their own volatility control fund.

The higher they go, the lower the volatility and the more levered up people get. It's the exact same self-fulfilling loop that's driving CTAs and risk parity to lever up their positions.

And for those who think this is a hypothetical, remember what SocGen observed the Monday following the tech selloff:

The big news of the week, of course, came on Friday, with a sell-off in US Technology and related stocks.

The sell-offs themselves are not particularly unusual, but the uniformity of the prices moves all on the same day indicates a market driven by price chasing momentum, with investors heading for the door all at the same time. Indeed, those S&P 500 stocks which sold-off on Friday were almost all from the strongest performing decile over the previous 12 months (the r-squared on the S&P 500 line in the chart below is 85%). Within Nasdaq the relationship is even stronger at 95%.

Such a uniform sell-off strikes us as systematic, especially as the relationship weakens once you look at the broader and less liquid Nasdaq composite. For price chasing investors, Friday's plunge serves as a warning; when it's time to head for the door, you better move fast.

In other words, by becoming synonymous not only with growth and momentum, but also with volatility, these tech names (be they "FANG" or "FAAMG" or "FANTASY" or whatever) have found themselves the centerpiece of multiple factor-based strats.

Not only that, in order to best benchmarks, hedge funds and mutual funds are also overweight these very same names.

In short, these stocks are everywhere - embedded in everything. And they're propping up the entire market.

We are quite literally living in a "FANTASY" world.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.