Wall Street Slaps Sell Rating On S&P's Newest Stock Sector

The sharp decline in many giant tech stocks in recent days has highlighted Wall Street's unhappiness with the new, high-profile stock sector created for the S&P 500: communication services. The recent reshuffling of S&P's sectors moved high-flying FAANG members Facebook Inc. (FB), Netflix Inc. (NFLX) and Google parent Alphabet Inc. (GOOGL) into this new group along with other internet and media growth stocks. But rather than becoming a new darling of analysts and strategists, the communication services sector has been receiving bearish reviews, Business Insider reports, as summarized in the table below. The decline of these mega cap tech stocks - which account for a huge share of the sector's market value - has dragged down the group's performance in recent days. That's just one of a long list of complaints about the sector, which we outline below. (For more, see also: 5 Ways The S&P 500 Stock Shuffle Will Affect Investors.)

Wall Street Firms Get Bearish On Communication Services

Firm Communication Services Rating
RBC Capital Underweight
Bank of America Merrill Lynch Underweight
Wells Fargo Unfavorable
Morgan Stanley Equal weight

Source: Business Insider

What Matters For Investors

The ratings for the new sector are negative, which is an effective sell rating, or lukewarm, per Business Insider and Morgan Stanley.

RBC Capital. They see declining earnings momentum among the big tech stocks now in communication services, with an increasing incidence of downward revisions in EPS estimates, and a decreasing incidence of positive earnings surprises in the second quarter. RBC also worries that Facebook and Alphabet are very popular holdings among hedge funds, and are heavily overweight positions in large cap growth mutual funds. If these institutional shareholders suddenly turn negative on these stocks, that could touch off a selling frenzy. Lastly, RBC notes that increased regulation of the big tech names could be another negative. (For more, see also: Hedge Fund Bets Mirror Dotcom Bubble, Only Much Bigger.)

Bank of America Merrill Lynch. They also cite regulation, spurred by matters such as privacy concerns and data breaches involving Facebook, as a possible negative for communication services. Also, if U.S. economic growth broadens, BofAML believes that investors might rotate out of crowded growth stocks and into other stocks that may benefit. The table below illustrates how the big tech stocks now in communication services have fallen from their highs.

Communication Services: The Biggest Players Are Falling

Stock or Index Price vs. 2018 High
Facebook (27.8%)
Netflix (17.7%)
Alphabet (10.9%)
S&P 500 Index (SPX) (2.0%)

Source: Yahoo Finance; data as of the market open on Oct. 9.

Wells Fargo.  "We have initiated guidance on the new communication services sector with an unfavorable rating," wrote Scott Wren, a senior global equity strategist at Wells Fargo, in a client note dated Oct. 1. He added, per Business Insider, "furthermore, because market downturns are often unexpected, we suggest holding asset classes that tend to do well when equity markets correct, such as high-quality bonds and hedge funds for qualified investors, consistent with an investor's risk tolerance."

Morgan Stanley. While Wells Fargo has ratings of favorable on consumer discretionary and neutral on information technology, Morgan Stanley is underweight on both, seeing excessive valuations in each. Regarding the new communication services sector, however, Morgan Stanley sees an attractive forward P/E ratio relative to the S&P 500 as a whole. Nonetheless, they do not see a buying opportunity here. 

Michael Wilson, the chief U.S. equity strategist at Morgan Stanley recently wrote, per Business Insider, "we would not classify this as a value sector." He notes that this sector's growth in forward earnings relative to the market peaked in late 2016. Communication services is down 5.6% YTD through Oct. 8, while the S&P 500 is up 7.9%, per S&P Dow Jones Indices. (For more, see also: 2 Big Red Flags For The Stock Market.)

Looking Ahead

In another report, Morgan Stanley sees trouble ahead for tech stocks in 2019, based on excessive valuations reminiscent of the dotcom bubble, per another Business Insider story. Meanwhile, Goldman Sachs sees a variety of concerns that may hurt profits across all industries in 2019. (For more, see also: Why Stellar Corporate Earnings May Not Boost Stocks.)

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