The market’s hottest stocks could be derailed by the Fed

Derailed train
How the FAANG group might look if the Fed keeps raising rates. SLC Fire Department via AP

The fate of the red-hot tech stocks dominating the US stock market could rest in the hands of the Federal Reserve.

The so-called FAANG group — consisting of Facebook, Apple, Amazon, Netflix and Google — has traded inversely to 10-year Treasury yields for the better part of the last decade, according to data compiled by Credit Suisse.

So if the Fed continues to raise interest rates as planned, those high-flying tech stocks are likely to come under pressure, at least if history is any indicator. And that will threaten a torrid streak of gains that’s led major indices to new highs.

The FAANG group has surged 25% so far in 2017, with each company climbing more than 20% over the period. That’s more than triple the return of the S&P 500, and a full nine percentage points more than the already tech-heavy Nasdaq 100.

“A move higher in interest rates in the 2H17 could be a challenge for the group from a trading/sector rotation perspective,” Credit Suisse chief US equity strategist Lori Calvasina wrote in a client note.

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FAANG performance has historically had an inverse relationship with 10-year yields, which could spell disaster for the group as the Fed continues to tighten. Credit Suisse

The same inverse dynamic is true for the more refined internet retail space, which consists of FAANG members Amazon and Netflix, but isn’t categorized as tech. Rather, the companies are both part of the consumer discretionary sector, according to S&P classifications. As such, the consumer space could also come under pressure as the Fed continues to tighten, says Credit Suisse.

The potential downside in both areas could be potentially jarring for heavily exposed fund managers, who have piled into the tech and internet retail trades with abandon. That’s resulted in overcrowding — something that’s fine on the way up, but can lead to a swift and painful comeuppance at the first sign of turbulence.

However, sell side analysts seem to have realised these possible perils, and have slightly scaled back bullish sentiment around FAANG. Given this shift in guidance, it’s entirely plausible that investors will follow suit and get more defensive, especially with an interest rate reckoning on the horizon.

Further, Credit Suisse points out that valuations for FAANG look entirely reasonable. The ratio of FAANG’s price-to-earnings ratio to that of the broader Russell 1000 is close to the lowest since 2003, according to the firm’s data.

Regardless of what the future holds, it’s clear that some questions are emerging around these mega-cap tech titans, which might not be the worst thing in the world. After all, if stock market history has shown anything, it’s that a dose of scepticism can be healthy.

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FAANG doesn’t look overvalued versus the rest of the stock market on a forward 12-month P/E basis. Credit Suisse