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August
10
2018

Facebook’s crash is everybody’s problem
Dan Denning

Editor’s Note: In late July, $120 billion was wiped from social media giant Facebook’s total market value. It was the worst one-day loss for any publicly traded company in Wall Street history. That was painful for anybody holding Facebook shares. But according to today’s guest editor, Dan Denning, falling tech shares are everybody’s problem.

Dan pens our Saturday Diary and shows why Facebook and its Big Tech brethren will fall and drag the stock market down with them…

A little over two weeks ago, Silicon Valley giant Facebook reported what one analyst described as “nightmare guidance.”

The social media giant reported that its user growth in the U.S. and Canada had flatlined… and that it was losing users in Europe.

Then, the company’s CFO, David Wehner, said he anticipated that rising costs would outpace sales growth in 2019, as the company grapples with better policing of fake news, hate speech, fake accounts, and election manipulation on its platform.

That’s when Facebook shares took a historic dive. They fell nearly 19%, from $217 to $176, in less than 24 hours. That move wiped more than $120 billion off the company’s market value – more than the entire market value of General Electric.

It was bad for Facebook shareholders, sure. But if you don’t own shares, then you might think that it’s not your problem. As the great TV personality John McLaughlin used to say, “Wrong!”

Here’s what you might not realize: You can be wiped out by falling tech stocks even if you don’t own the companies outright

Leading the Bull

Facebook, along with its Big Tech brethren, has had an outsized effect on the returns of the broader stock market.

The often-cited FAANGs – Facebook, Apple, Amazon, Netflix, and Google’s parent company Alphabet – have a combined market cap of $3.4 trillion. Apple alone is now worth $1 trillion. If you add in Microsoft’s $840 billion market cap, you get six companies worth over $4.3 trillion. 

What’s more, the FAANGs, along with Microsoft, account for almost all of the gains in the S&P 500 for the year…

Chart

That’s all well and good when Big Tech firms are growing profits fast. For the past 10 years, there was nowhere to go but up. Low rates from quantitative easing (QE) made the stock market a lot more attractive than bonds, and high rates of growth made the tech stocks a lot more attractive than value and quality ones.

But the Facebook earnings call might as well have been a bell. When profit growth at these companies falls, their share prices take a tumble. The bigger you get, the harder it is to grow at double-digit rates (nearly impossible). That’s what Facebook told analysts. And when it did, it showed that falling tech stocks drag the rest of the market down with them.

By the way, it’s not exactly a revelation that falling market leaders drag the market lower. It’s happened before. It happens nearly every time at the top of the market. For example, between January 1995 and March 2000, the dot-com stocks helped drive the tech-heavy Nasdaq index up 553%.

Boom! New era! New economy! Pets.com!

But when the dot-com bubble popped in March 2000, the Nasdaq plunged 78% over the next 31 months. Tech darlings Intel and Microsoft shed $90 billion and $80 billion, respectively, in market value in a single day. And the broader S&P 500 plunged 49% in 31 months.

That’s what I mean when I say crashing tech stocks can wipe you out even if you don’t own them directly. And yes, I know that buy-and-hold investors will tell you that if you simply close your eyes, hold your nose, and take a deep breath, periodic drawdowns of 50% in your portfolio are worth the stress.

What they won’t tell you is that we’re in the later stages of the third consecutive bubble in financial asset prices. The first was the dot-com bubble. Then came the housing bubble. And now, since 2009 and QE, we have this bubble in everything, led at the front by techs.

All bubbles pop. So will this one. And the biggest and best overpriced tech stocks will crash. How can I be so sure? Because there are three specific threats facing Big Tech. One way or another, the music is about to stop.

The First Threat

The first threat to Big Tech is what we saw happen with Facebook a few weeks ago.

For years, Facebook has delivered growing numbers; new users were spending more time on Facebook, and then on WhatsApp and Instagram after those companies were acquired. The advertising dollars poured in.

Of course, that’s what you want with a growth stock. The company is growing earnings at a rate significantly higher than more traditional stocks in the S&P 500. Investors are willing to pay more for current earnings and forgo dividend payments because they see higher earnings ahead. Consider it a premium that you pay for above-average earnings growth.

Since 2012, Facebook grew its earnings per share from about $0.12 to $1.74. That’s a compound annual growth rate of 56%. Investors poured money into Facebook because they expected that sort of growth rate to continue. And it did… for awhile.

Before the stock cratered in July, Facebook was trading at a price-to-earnings (P/E) ratio of nearly 34. That’s about 127% higher than the average P/E ratio for the S&P 500, which is 15.

But during its second-quarter earnings call, Facebook forecasted decelerating revenue growth for the remainder of the year. Investors took that to mean that Facebook is no longer a growth stock. Therefore, it no longer deserved a growth premium. And everyone hit the sell button.

The same thing could happen to any of the FAANGs if Wall Street analysts see falling growth ahead. And because they’re all so big, delivering the same rates of growth is now much harder. 

Amazon, with its growing cloud-computing business and its expanding reach in retail, might be able to keep the train running. But Google? Netflix? Microsoft? Apple? Where will the new customers come from? China? Or will growth come from spectacular breakthroughs and more innovation?

Maybe it will. But it’s in the nature of technology that large, powerful incumbents are at risk of massive disruption from smaller companies. So far, Big Tech has avoided that risk by buying up the competition before it can compete.

As my colleague Jeff Brown has shown, many of the Big Techs could face their day of reckoning from blockchain technology. If you look beyond bitcoin, blockchain is the real force of creative destruction that should keep the Silicon Valley robber barons up at night.

That’s threat one. But there’s more…

The Antitrust Argument

Earlier this year, The Wall Street Journal ran an article titled, “The Antitrust Case Against Facebook, Google and Amazon.” The argument laid out there is one that I expect will become more popular among politicians, especially as we get closer to the midterm elections: Break up the Big Techs.

The Big Tech companies have become powerful monopolies in their respective industries. It may not be harming consumers yet, but it is stifling competition and innovation. What do I mean?

Google drives 89% of internet searches. One-third of people search Amazon first when looking for a specific product online. And Facebook has about 2.3 billion monthly active users… That’s around a third of the world’s population.

That sort of dominance, driven by the network effect, makes competition impossible. Who can compete with 2 billion users? Who’s going to break Google’s death grip on the search box?

You could argue that these companies deserve their market positions. They make products that people find useful. If someone wants to beat them, go for it. That’s how the free market works.

But a monopoly situation is no longer a free market. And politicians on both sides of the aisle smell blood in the water with techs. I guarantee you that these companies will be at the center of the political debate during this year’s midterm elections. Politicians are already coming after them.

Democratic New York attorney general candidate Zephyr Teachout promised to break up Google and Facebook under federal antitrust laws if she’s elected in November. And recently, Senator Mark Warner – also a Democrat – published a policy paper suggesting 20 ways to crack down on Big Tech… including promoting competition in the tech space.

Even if these companies never get broken up, regulators can still hit them with heavy fines. Google’s been fined over $7 billion in the last two years by the competition regulator in the European Union. Even for a cashed-up company, that’s a lot of cash.

What’s the impact on investors? All of this uncertainty in the political sphere will act as an air brake for Big Tech. The chance of more fines or a regulatory push to break up the Big Techs on antitrust grounds adds an element of risk to the stocks that hasn’t existed during this bull market.

It also adds an element of uncertainty. Uncertainty is a fact of life. But for investors, it’s annoying. It makes it harder to project future earnings, and therefore, harder to figure out what a stock is worth today.

Then, there’s threat number three…

Walk Away

The last one is the simplest to understand. Folks could finally get sick of the products that these companies provide – especially when they realize the internet has become a massive surveillance machine, dominated by a few big companies that were either funded by the Intelligence Community or are now happy to do its bidding and spy on Americans, while trying to modify their behavior through algorithms.

There’s already a lot of resentment toward Big Tech in general, and Facebook, specifically. You may not have to pay to use Facebook, but you give the company something much more valuable in return for its services: your personal data.

We’ve always known that Facebook harvests vast amounts of our personal data. You’d have to be living under a rock not to know that the company hawks this data to advertisers and political campaign managers to help them modify our behavior – to get us to buy stuff or vote for someone.

And judging by Facebook’s more than two-billion-strong user base, people have been okay with that trade-off. But what the Cambridge Analytica scandal – as well as Facebook’s “fake news problem” – showed is that our data is being used for reasons other than connecting us with products we may want to buy.

The same data and algorithms that serve you targeted ads are also being used to manipulate – or “nudge” – you toward voting for a particular candidate or cause. Or, worse, your data is being used to identify you as a particular “threat vector”: a terrorist; a loner; or even a lover of cash, limited government, and individual liberty.

Human beings resent being manipulated. We understand that being watched all the time and being not-so-subtly nudged to behave in a certain way, or to hold the “right” views and be compliant with authority, is the opposite of being free. It’s becoming subservient to a giant surveillance machine controlled by people who think they know better than you on how to live your life.

Here’s a prediction: The tech backlash will pose a problem to the business model of these Big Tech companies.

Definancialize Your Life

Readers of The Bill Bonner Letter will know this argument too well. But I’ll repeat it here for Diary readers. This is too important for you to ignore… 

Protecting the wealth you already have is more important right now than putting your entire nest egg on the line in the stock market for another 10%, or even 20%, gain on the index. In the context of a 70% decline in Big Tech stocks (and a 50% decline in the overall market), is another 20% really worth it?

Part of what I’ve told readers of The Letter to do is to look at “definancializing” your life. That means taking some of your wealth out of the financial system. That system, especially the stock market, is far more vulnerable than most realize.

Put at least some of your wealth into tangible assets that you can physically own. We discussed this in detail last year in a report on asset allocation. Our strategy leaves some of your money in stocks (after all, we can’t predict the future). But it’s a lot less than most traditional 60/40 models (60% of your investable assets in stocks, 40% in bonds).

In fact, we recommend you own almost no bonds. If there’s one market that’s even more dangerous than stocks right now, it’s bonds. Instead, we recommend an allocation to real estate, cash, and precious metals. (The full strategy is available to readers of The Bill Bonner Letter, and I’ll be updating it next month.)

Diversifying your investments won’t protect you from everything that’s coming down the tracks for the U.S. stock market. It’s hard to hedge a bear. Owning stocks means taking risks. But diversifying into real assets will help protect you – and your wealth – from the worst of what I see coming.

Regards,

Dan Denning
Coauthor, The Bill Bonner Letter

P.S. As I mentioned, if you haven’t already, I encourage readers of The Bill Bonner Letter to review our “new permanent portfolio” by going right here. I’ll be updating the allocation in a future issue. 

And if you’re not a subscriber to The Bill Bonner Letter, then consider joining Bill and myself by going here. The strategies I share with readers won’t protect you from everything during the next financial crash. But it will insulate you, and your wealth, from the worst of it. Again, go right here.



 

Dan Denning is the coauthor of The Bill Bonner Letter. Every month, he and Bill pen their contrarian thinking to provide insights you won’t find anywhere else. 

Before joining Bonner & Partners, Dan was a founder of Southbank Investment Research, the leading independent financial publisher in the UK. Dan is also the author of the 2005 book, The Bull Hunter

Dan Denning’s belief in free markets, sound money, personal liberty, and small government have underpinned everything he’s done during his 18 years in the financial publishing industry.

 

 

 

  

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