Social Media Stocks Wobble Yet Again After Fed Valuation Warning

Jul 16, 2014 1:40 pm ET

July 16 (Bloomberg) -- Internet and biotechnology stocks, at the center of almost every volatility scare the U.S. stock market has seen in an otherwise calm 2014, were back in the lurch yesterday.

Valuations for smaller biotechnology and social media stocks are stretched, the Federal Reserve said in its Monetary Policy Report delivered to Congress yesterday. The Russell 2000 Index of small-cap shares sank 1 percent, closing at the lowest level almost six weeks. The Nasdaq Biotechnology Index lost 2.3 percent and the Global X Social Media Index exchange-traded fund retreated 1.1 percent.

Smaller technology stocks command some of the highest valuations in the market amid investor demand for companies with the potential to boost profit in a sluggish economy. Concern that earnings at biotechnology, Internet and small-cap companies don’t justify their share prices made the industries the biggest losers in a market retreat earlier this year.

“A lot of people are blaming the Fed, but with valuations this high you don’t need an excuse to sell,” Eric Cinnamond, manager of the $724 million Aston/River Road Independent Value Fund, said in a phone interview yesterday from Louisville, Kentucky. “Small-caps are being priced as if we’re on this growth trajectory that’s not quite there. They’re priced for fantasy land.’

Stocks Rebound

U.S. stocks rose today as companies from Apple Inc. to Time Warner Inc. and Intel Corp. rallied amid deals and earnings reports while small-cap shares recovered. The Standard & Poor’s 500 Index added 0.4 percent to 1,980.69 at 1:36 p.m. in New York.

The S&P Smallcap 600 Index trades at 26 times reported profit, while the Nasdaq Biotechnology Index has a multiple of more than 500, according to data compiled by Bloomberg. The broader S&P 500 has a price-earnings ratio of 18, the most expensive valuation since 2010.

The ETF tracking social-media shares fell yesterday, with losses exceeding 2.5 percent in Yelp Inc. and Zynga Inc. Facebook Inc., which trades at 90 times earnings, slid 1.1 percent to $67.17.

‘‘Equity valuations of smaller firms as well as social media and biotechnology firms appear to be stretched, with ratios of prices to forward earnings remaining high relative to historical norms,” the Fed said in the report.

Spooked Market

It’s unusual for the central bank to give specific commentary about industries in the equity market, said Paul Zemsky, head of multi asset strategies at Voya Investment Management LLC.

“The market just got spooked with the mention” of biotechnology and social media stocks, Zemsky said by phone yesterday in New York. Voya oversees $213 billion. “We’re in a new era of macro policy where the Fed is using new tools to prevent bubbles and raising vocal concerns when markets are away from fundamentals.”

Officials have made broader cautionary statements about valuations for smaller companies this year. In February, Fed Governor Daniel Tarullo said the surge in small-caps was one reason policy makers should ensure they weren’t creating systemic risk in financial markets.

With stocks hovering near record highs, Yellen signaled yesterday that she isn’t worried about frothy markets in general, saying in prepared remarks that equities, real estate and corporate bond values are in line with historical norms. The Fed needs to hold its benchmark policy rate near zero, where it’s been since December 2008, until the labor market improves and inflation accelerates, she reiterated.

Occasional Exuberance

“I’m not particularly troubled by occasional exuberance and higher prices for certain stocks than may be justified,” John Carey, a Boston-based fund manager at Pioneer Investment Management Inc., which oversees about $220 billion, said in a phone interview yesterday. “It’s a sign that people are interested in growth and owning stocks and intrigued by new business opportunities.”

Small-caps and Internet shares suffered the biggest losses amid an equity retreat during March and April as investors dumped the best performers of the bull market. The S&P 500 fell as much as 4 percent, while the Nasdaq Composite Index and the Russell 2000 sank more than 8 percent.

The stocks rebounded as investor appetite for risk returned. The Nasdaq gauge reached a 14-year high this month and before last week, the Russell 2000 had recouped most of its drop.

Yellen, responding to questions yesterday from the committee, said low interest rates can be conducive to the formation of bubbles, and that the Fed was watching carefully for signs of such increased risk-taking. She cautioned that the central bank will not “be able to catch every asset bubble.”

“The broad sentiment is just one of caution,” Mark Freeman, who oversees about $19.1 billion as chief investment officer at Westwood Holdings Group Inc. in Dallas, said by phone yesterday. “We’re in an environment now where the fundamentals have to deliver.”

--With assistance from Lu Wang and Joseph Ciolli in New York.