Investor's Edge

If tech falls apart, two sectors—financials and industrials—can save the market

Key Points
  • Facebook, Amazon, Apple, Netflix and Google-parent Alphabet are in correction mode, with a collective 10 percent drop.
  • Should the group pull the entire tech sector down, investors will need to find alternatives as tech makes up more than a quarter of the S&P 500 in terms of market cap.
  • Nick Colas at DataTrek Research has studied the weighting issue and said financials and industrials are the two best candidates to rescue the market from a tech correction.
FANG stocks (Facebook, Amazon, Netflix and Google) apps on a smartphone.
Adam Jeffery | CNBC

Five stocks stand in front of Wall Street's bull market, threatening a rally that has withstood some wicked bouts of volatility in 2018 to continue powering higher. Two sectors could come to the rescue.

The FAANGs — Facebook, Amazon, Apple, Netflix and Google-parent Alphabet — have been undercutting a market that has benefited from roaring corporate earnings and a substantial boost in economic growth. Together, the stocks are down an average of 6 percent over the past five trading days and fully into correction territory since their June highs.

While the broader technology sector is still a ways away from a correction, or a decline of 10 percent from its most recent highs, investors may want to start thinking about alternatives.

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The FAANGs just themselves have taken up an outsized space in investor portfolios. The companies account for 15.4 percent of the market cap in the SPDR S&P 500 ETF, the most popular exchange-traded fund with $272.9 billion in assets.

In addition to the high FAANG concentration, tech stocks overall make up just shy of 26 percent of the , nearly double the concentration of the next largest sectors, health care and financials.

Should tech capsize, Nick Colas, co-founder of DataTrek Research, has looked at alternatives to the group and come up with a couple: financials and industrials. In his daily note to clients, Colas explains:

• Financials are working right now (+6.7% over the last month), thanks to a steepening yield curve and decent earnings. They are cheap to 12-month forward earnings (12.7x) and are one of the few sectors still below their 2007 highs. The group also has an outsized weighting in Value indices, likely winners of capital rotation in a Tech meltdown.

• Industrials aren't especially cheap (16.5x forward earnings), but the group is still +6.5% over the last month and now even up on the year (0.5%). Trade tensions obviously still weigh on the sector, even with recent positive news on that count.

The other sectors, such as energy, materials, real estate, telecom, staples and utilities, lack sufficient market cap to make up for the tech hit. Together, they compise just 23.1 percent of the S&P 500 market cap, less combined than tech is alone. Health care is one natural alternative, but that move already may have begun, Colas said.

Disrectionary "isn't likely to help," as Amazon and Netflix together account for more than 29 percent of that group's market cap, Colas said.

"There is a 'Path to victory' for the S&P 500 if the index loses the Tech sector, and it runs straight through Financials and Industrials," Colas wrote. "The former needs the yield curve to steepen (something we think likely). The latter could really use some good news on the trade front (possible, if only because the president likely wants some wins to campaign with ahead of midterm elections)."

He added that the strategy assumes a slow burn for tech rather than a sudden plunge. In the latter case, he figures that money would flee U.S. stocks overall with little time for sector adjustments.