FAANG Stocks Get Their Bite Back

The FAANG group of tech stocks led the market in 2017, but a number of top market strategists predicted that they would lose their bite in 2018, largely based on what many investors see as their stretched valuations. These experts have been proven very wrong so far.

A simple average of the year-to-date gains for the FAANG stocks through February 26 was 20.5%, versus a 4.0% increase for the S&P 500 Index (SPX). In 2017 the respective figures were 49.2% and 19.4%. Thus, the ratio of gains between the average FAANG stock and the broader market has jumped from 2.5 times in 2017 to 5.1 times so far this year.

Big Gains For FAANGs

For the FAANG stocks, their respective full year 2017 gains and year-to-date 2018 gains through February 26 are:

• Facebook Inc. (FB): +53.38%, +4.69%
• Apple Inc. (AAPL): +48.47%, +5.74%
• Amazon.com Inc. (AMZN): +55.96%, +30.40%
• Netflix Inc. (NFLX): +55.06%, +53.42%
• Alphabet Inc. (GOOGL): +32.93%, +8.25%

The FAANG stocks are big drivers of the capitalization-weighted S&P 500 given their huge market valuations. Apple, Google parent Alphabet, and Amazon are the top three S&P 500 members based on market cap, while Facebook is in 5th place and Netflix is 41st, per CNBC.

NFLX data by YCharts

Great Expectations

The technology sector continues to be an especially pricey niche within this expensive market, and some of the FAANGs are in the valuation stratosphere. Per data from CNBC, the forward price/earnings ratio on the S&P 500 is 20.6 times projected earnings, while that for the technology sector is 28.9 times. Facebook is at 25.5 times, Amazon at 184.3 times, Netflix at 107.4 times, and Alphabet at 27.6 times. Sticking to its historical discount, Apple is the only FAANG with a PE below the market, at 14.6 times.

These PE ratios generally reflect highly optimistic expectations among investors for future growth. Given the heavy weighting that these stocks have in the S&P 500 and other key market indices, serious earnings disappointments among the FAANGs and other big tech companies may have highly negative consequences for the market as a whole, bearish analysts warn. (For more, see also: Why Amazon, Microsoft, Netflix Pose a Risk to Stock Market.)

Paying For Growth

Amazon and Netflix are able to command such incredible valuations because their investors are focused on future growth, rather than profits now. Netflix is operating at a profit, but cash flow from operations remains negative. Nonetheless, investors apparently like what they see in the growth trend of revenues and subscribers, Business Insider reports.

Amazon generates both positive earnings and cash flow from operations. Although net income for the fourth quarter was a paltry 3.1% of sales, the 38% year-over-year increase in revenue is what apparently impressed investors, per CNBC. Amazon's astonishing P/E multiple implies expectations that the company can continue growing at a torrid pace well into the future.

NFLX Annual Revenue Estimates data by YCharts

Laggards Still Lead

Despite news that has disappointed investors to varying degrees, shares of Alphabet, Apple and Facebook still have managed to beat the S&P 500 so far in 2018. For Alphabet, fourth quarter revenues and earnings were up sharply from a year ago, but earnings nonetheless fell short of analysts' forecasts, creating a temporary sell-off in the stock, USA Today reports. Facebook is encountering a slowdown in user growth in its home market of the U.S. and Canada as well as in Europe, prompting advertisers to explore other options. (For more, see also: Facebook's Growth Threatened By Twitter, Snap.)

With Apple, indications of weak iPhone demand have led to downward revisions in future estimates of revenues and earnings. The company also has drawn fire over claims that it deliberately slows the performance of older iPhones in order to spur sales of replacements. (For more, see also: Apple Analysts Slashing Estimates Is Red Flag For Stock.)

FAANG Stories

For the moment, investor - and consumer - excitement about the technology products and services may play a role in bolstering these stocks. For one, marketing professor Scott Galloway believes that Amazon's core competency is mesmerizing investors with stories about future growth, thus making sure that they do not get obsessed with earning short-term profits, let alone dividends. One might argue that the other FAANG companies also rely on spinning stories about the future, to varying degrees. Should investors tire of these tales, and start to demand more tangible current results, valuations and share prices may be in for a severe downward adjustment.