Valuation Scare in Nasdaq Arrives at Wrong Time for U.S. Bulls

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  • FANG stocks slide by average of 7.6 percent in three days
  • Nasdaq slumps 19 percent from July high to near bear market

Before last week, it would have been hard to say valuations were a pressing concern for U.S. stocks -- particularly after 2015’s market was propped by a handful of companies with triple-digit multiples. That’s changing.

Declines in last year’s stalwarts, from Facebook Inc. to Inc., punished the Nasdaq Composite Index for the third straight day Tuesday, pushing the gauge’s rout since the July record to 19 percent and leaving it at the lowest since October 2014. Once again, selling was heaviest in shares with the highest price-earnings ratios and among momentum stocks, causing the engine of the bull market to sputter as it nears its seventh anniversary. The gauge added 0.4 percent at 9:50 a.m. in New York.

“Some of those got way over-extended in terms of valuation and really weren’t trading on valuation either, they were just trading on growth and momentum,” said Sean Lynch, co-head of global equity strategy for Wells Fargo Investment Institute. “Anytime you start to see cracks in the market or worries about the economy build up, certainly valuation becomes a little bit more of a focus.”

While the usual culprits weighed on sentiment again Tuesday -- China, oil, profit growth -- it’s been the sharp reversal of once-mighty leadership stocks that has investors wondering whether any company is safe. Almost half of the Nasdaq’s 2,600 members -- including Netflix Inc., EBay Inc. and Biogen Inc. -- have slumped at least 20 percent since the gauge peaked in July, satisfying the definition of a bear market.

The 100 highest valued companies in the Russell 1000 have dropped twice as fast as stocks in the least-expensive decile in each of the past two days, while momentum stocks, defined as the ones showing the biggest gains in the last six to 12 months, have stopped rallying after returning 32 percent as a group in 2015.

Accelerating weakness among the “last remaining holdouts” -- including the so-called FANG stocks credited with buoying the index last year -- confirms other technical signals pointing to continued rout this year, said Jonathan Krinsky, chief market technician at MKM Partners LLC in New York.

“The army is losing its generals,” he said. “The leadership stocks hang tough as long as they can and then eventually they start to rollover and because they’ve become such a heavy weighting in the overall market, that brings the overall market down.”

Facebook’s plummet shows how quickly sentiment can reverse, even after the company surged 16 percent last month the day after its results topped forecasts. The stock has slipped 16 percent in six sessions. Its valuation has fallen almost 30 percent since December, though at 76 times reported earnings it is still triple the average for companies in the Nasdaq index.

And Facebook’s cheap compared with Amazon, which peaked at a valuation of more than 1,000 times earnings just six weeks ago before the metric plunged by 60 percent. Shares of the online retail giant have tumbled 25 percent since Jan. 28.

At least two Wall Street brokerages in the past week identified as a bubble the rallies in momentum stocks such as Google parent Alphabet Inc. and Netflix. Cornerstone Macro’s Francois Trahan and Stephen Gregory said economic uncertainty has driven investors into momentum stocks and pushed valuations to “epic proportions.’’

For Marko Kolanovic, the New York-based head of global quantitative and derivative strategy at JPMorgan Chase & Co., the selloff highlights the risk of concentrated bets, especially when valuations are stretched. The FANG group -- Facebook, Amazon, Netflix and Google -- has lost almost 19 percent on average this year, compared with a rally of 83 percent in 2015. Even after the recent selloff, the quartet is valued at a median price-earnings ratio of 185. That’s more than 10 times the S&P 500’s multiple of 16.5. 

The decline of some of the high flyers may be necessary to give the market “a little bit of cleansing,” Wells Fargo’s Lynch said. Even so, the magnitude of the latest two-day selloff is of concern if it creates a negative feedback loop in which equity weakness leads to widening credit spreads, thereby dragging down business and consumer confidence and eventually giving more credence to recession fears, he said.

Beyond tech stocks, the slump in financials and energy shows that a larger dynamic is at play as investors unwind their leveraged bets, while weak oil and credit-market stress exacerbate weakness, said Dave Lutz, the Annapolis, Maryland-based head of exchange-traded funds trading for JonesTrading Institutional Services. An exchange-traded fund of biotechnology companies -- many of which are in the Nasdaq -- has fallen 8.7 percent in the past three days to the lowest since June 2014.

“A lot of these momentum companies that people had been ignoring valuations, if you will, and just bidding up the theoretical prospects of what’s going to happen in the sector -- a lot of that’s just reversing sharply right now,” Lutz said. “A lot of leveraged bets are coming off the market at the moment.”