Markets Deliver a Lesson in Stock Pricing and the Role of Investor Expectations.
FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) have been stock market darlings for the past year. Big tech stocks outperformed everything else on the market over the past couple of years.
Investors took notice, and bid the stocks up to tremendous heights. And why not? Amazon seems to be taking over the world. Google's dominance of online advertising is virtually uncontested. Facebook (for better or worse) has captured the eyes and attention of the world for countless hours out of every day, and Netflix seems to be an unstoppable force in the entertainment world.
But this week, all of these stocks are down sharply, falling much further than the overall stock market.
There is a lesson in this for investors.
No one doubts that Amazon remains a powerful force. But is it a good investment AT THE CURRENT PRICE?
The price of ANY stock depends on investors EXPECTATIONS regarding future profits of the company. If investors EXPECT that Amazon will take over the entire economy, they will bid up the price until it reflects that eventual reality.
But what if EXPECTATIONS CHANGE? What if SOMETHING HAPPENS, such that investors begin to allow for other, less perfect outcomes? Or what if new challenges appear that threaten to increase costs and reduce future profits. Notwithstanding the fact that these remain great companies with bright futures, the stock price will fall if TODAY'S EXPECTATIONS ARE LESS ROSY THAN YESTERDAY'S.
Over the past couple of weeks, investors assumptions about Big Tech have changed. There were several catalysts, including Facebooks privacy debacle, President Trumps tweets disparaging Amazon, and content and privacy issues impacting Google. The specter of costs associated with increased government oversight and regulation have forced the market to consider less ideal scenarios for future profit growth.
A lesson for investors is this - just because a firm is powerful and has a compelling story does not mean its stocks will only ever go up. In order for a stock to continue to move higher, INVESTOR EXPECTATIONS regarding the company's future profit growth have to continue moving higher.
The recent problem with FAANG stocks is that investors had already priced in an expectation of complete and utter world domination by these five companies. It is hard for expectations to actually get much higher than that! The recent pullback in FAANG stock prices is simply the market realizing that there may be other, less perfect potential outcomes that are possible as well.
Another powerful lesson to learn - Diversification still matters. Today's king may very well be tomorrow's dog. Broad diversification limits your exposure to events which disproportionately impact one piece of the market.