Stock Market Comment: Is tech stock rally at risk?

• Tech stocks outperform broad market this year

• Revenue growth rates slow below 5-year averages

• Companies fear ad spending collapse

• Growth-to-value ratio above dot-com bubble peak

• Nasdaq (US100) makes another test of 78.6% retracement

Investors are puzzled over what to expect next. On one hand, they see disastrous economic data almost everywhere they look. On the other hand, the stock market does not seem to be too concerned about it. Tech stocks from NYFANG+ group were big drivers for S&P 500 in 2019 and in this short commentary we will try to determine whether their outperformance may last this year as well.

Majority of NYFANG+ stocks outperformed S&P 500 this year. Source: Bloomberg, XTB Research

We will not focus on all NYFANG+ stocks as we will omit Tesla (TSLA.US) and 2 stocks that did not report earnings yet (Alibaba and Baidu). We are left with Apple, Amazon, Twitter, Facebook, Microsoft, Alphabet and Netflix. As one can see on the chart above, Twitter is the only stock from the group to lag S&P 500 this year. The second worst performing stock - Alphabet (GOOGL.US) - is trading flat year-to-date against -12% for S&P 500. Having said that, we can see that those stocks are already outperforming the broad market by a huge margin. However, will this upbeat performance last?

Tech stocks experience positive revenue growth in Q1 2020 but below 5-year averages in most cases. Source: Bloomberg, XTB Research

In the table above we have compiled basic information on revenue and net income of the earlier mentioned companies. As one can see, every stock from the group managed to increase sales in Q1 2020. Moreover, only Apple failed to meet market consensus. This could lead to a false impression that everything is good for these stocks… it is not. The two rightmost columns of the table tell it all - NYFANG+ stocks experienced weaker sales growth than geometric average for the past years. This is even the case for Netflix, who is seen as one of the biggest winners of the stay-at-home push and experienced a massive inflow of subscribers in Q1 2020. The only two that managed to report above-average results were Microsoft and Amazon. All 7 stocks combined generated revenue of $226.8 billion in Q1 2020. It was a 14.5% YoY increase, slightly below the 5-year average of 15.5%.

Collapse in Twitter net income explains stock's underperformance. Source: Bloomberg, XTB Research

Net income data is much less encouraging than sales data. 5 out of 7 stocks reported lower earnings than in the previous year. Combined revenue of those 7 companies stood at $37.7 billion in Q1 2020, marking a lacklustre 0.4% YoY growth. Net income data also explains outperformance of Netflix and underperformance of Twitter this year (see year-over-year changes). Microsoft surfaces as a winner from both tables as it managed to boost earnings and revenue, achieve above-average sales growth and beat market expectations in both terms. The software company has been expanding its cloud computing unit in recent years and it pays off now as demand for such services was boosted by working from home. Thanks to this, the company's business is expected to continue to thrive this year with a potential to completely offset virus-related issues. 

When it comes to other companies, it is a bit more complex. 

• Netflix said that it expects strong subscribers in the second quarter of the year before it fades in the Q3 and Q4 when economies reopen. Note that the company may even see a net outflow of subscribers once people return to work. 

• Amazon expects strong demand for e-commerce to last in Q2 2020 and sees sales growing 25% YoY in the quarter. On the other hand, growth in Amazon's AWS cloud was weak in Q1 2020 pointing to a limited boost from working at home

• Apple has been hit by supply disruptions related to Covid-19 pandemic. However, data from China shows that smartphones sales rebounded very quickly. If China is any guide for reopening of the rest of the world, Apple may not have a bad year at all. However, company did not issue guidance along with Q1 2020 results

• Ads are the most important source of revenue for Facebook. While the company managed to outperform in Q1 2020, ad spending is likely to fall during a recession. Another source of concern could be lowering of CapEx guidance to $14-16 billion from previous $17-19 billion.

• Alphabet enjoyed strong growth in cloud services in Q1 2020 as well as solid demand for cloud services and apps. However, revenue from ads in company's search engines declined. Risk for Alphabet is the same as for Facebook - slowdown in ad spending.

• Twitter experienced 24% YoY in monetizable daily active users for Q1 2020. However, the company also said that its total advertising revenue dropped by 27% in the second half of March. This is an important insight not only for Twitter but also Alphabet and Facebook as it hints that Q2 could see a big drop in ad revenue

Ratio of Russell 1000 Growth to Russell 1000 Value topped dot-com bubble peak. Source: Bloomberg

Last but not least, a word of caution about valuations is needed here. Steep sell-off of the broad market and relative outperformance of tech stocks has raised concerns that a bubble is forming. On the chart above one can find a ratio of Russell 1000 Growth index to Russell 1000 Value index. This ratio has recently jumped above 1.6 and is the highest on a record. This means that it is also higher than it was during the dot-com bubble, when tech stocks were believed to be highly overvalued.

Summing up, potential collapse in ad spending in the future quarters could be a big risk for NYFANG+ stocks and Nasdaq index (US100) as they make up a big share of it. This could put an end to the tech stock rally we are observing right now. Nevertheless, we will likely have to wait for Q2 2020 data to find out. Of course, it is possible that no such collapse will occur. However, even then caution is needed as valuation of tech stocks are very high. It does not mean that those companies do not have solid business... they do but the risk of buying an overvalued stock from this group is very high now, especially as China and the United States may reignite their trade war any second. Still the outlook for tech stocks is better than for companies operating in the non-virtual economy. Having said that, it may be a wise move to wait for a correction before investing in tech companies.

Nasdaq (US100) is the top performer among major US indices. The index is making a second attempt of breaking above the resistance zone at 78.6% Fibo level of the February-March sell-off. US100 has been respecting local market geometries (yellow rectangles) throughout the recovery run. Keeping that in mind, the first big support to watch in case a pullback occurs can be found at around 8,500 pts, where 61.8% retracement and lower limit of market geometry can be found. Source: xSation5