Stocks broadly took a beating today, with the S&P 500 and Dow Jones each down over 3%. This accelerates a downward trend that started in late September, pushing the S&P 500 down almost 5% in total, with most other stock markets (international, emerging, small caps) down closer to 6%-7%.
Do we expect the volatility to continue? Are we seeing a change in market direction? What are the equity and bond markets telling us?
Our quick take on the action:
We have expected greater volatility this year, and in coming years. Volatility has been well below average, and investors have gotten used to a slow-and-steady rise in the markets. But markets don’t tend to move that smoothly.
Bottom line, we work carefully with clients to set a mutually agreed upon risk profile and spending policies in portfolios, to help weather periods of inevitable and unpredictable volatility in markets.
BOND YIELDS AND ECONOMIC GROWTH
Bond yields have continued to rise this year for two basic reasons: 1) the Fed is raising rates (affecting short term Treasuries) and 2) US economic performance has strengthened (affecting the 10-year). For much of this year, improving economic prospects have encouraged investors to favor riskier investments like stocks over bonds. This dynamic is, in part, why a handful of high-growth tech stocks have done well.
We have long expected this increase in rates, so as a matter of policy we have maintained bond portfolios with relatively short duration. As yields move higher, we are able to reinvest maturing bonds into more favorable pricing terms.
As an aside, we are pleased to see the Fed gradually raising rates. It should bring greater flexibility to monetary policy in later years, when we may need it.
More notably, though, the yield curve has become flatter (i.e., the difference between long-term yields and short-term yields is smaller), which can imply growing concern about a slower economy. Frankly, however, the curve has been flattening for much of this year, and has already had an impact on the stock market in our view. Consider that cyclical stocks like banks and industrial manufacturers (non-tech!) have lagged the broader market; we have added them to portfolios opportunistically. If the curve flattens further, we look to the fixed income allocation to serve its role in dampening portfolio volatility.
As a final observation, higher yields at some point make bonds relatively more attractive to stocks, and this condition seems to be driving much of today’s action. As yields approach 3.5% on the 10-Year, for example, we would not be surprised to see stocks slide a bit and bond prices to rise. This is a normal balance, and our portfolios strive to accommodate these dynamics.
THE BREAK-DOWN IN TECH STOCKS
Over the past week, tech stocks collectively are down almost 8%–more than the market average.
A narrow group of high-flying tech shares have been the beneficiary of a unique confluence of events: low rates that artificially boosted capital spending, strong organic growth often perceived to be immune to a trade war, and a strong US dollar. These stocks have disproportionately driven the market to date.
Are shares about to roll over after a long run? As we have written, they are very expensive and are being driven by thin dynamics: Stock Momentum and long-term expectations for growth. We see above average risk to them, and have avoided them. Calling the turn is difficult, but it is unlikely they will generate the best returns from recent levels.
TIME TO MOVE INTO MORE DEFENSIVE STOCKS?
We are seeing some managers rotating from tech shares into health care stocks, on concern that slowing economic growth requires a more defensive stance. We certainly have health care stocks in client portfolios, although we are not overweighting them as a defensive call. Why? We rely on defense through allocations to fixed income, whose prices move differently from stocks. We do not look to sacrifice long-term appreciation through shorter-term guesstimates about the economy.
Similarly, we see people wanting to get defensive as US stocks hit all-time highs. Relative to earnings, however, we do not see markets as artificially stretched. We do expect earnings growth to moderate next year, after an arguably one-time boost from the tax stimulus.
BOTTOM LINE OBSERVATION
Market dynamics in September were notably different from those at play for most of this year. We are seeing signs that what has not been working (value, cyclicals, international) is gaining favor, while the dominant forces (tech, momentum, high expected growth) may be reverting. There’s no clear theme emerging, yet, however, and it is too early to call a trend.
More broadly, we may be seeing an indication that investors are looking beyond a low-rate, benign growth environment that rewards a limited set of investment strategies. We have little faith in economic crystal balls, so we will continue to balance our portfolios based on objective evaluation of risk-reward and client objectives, which is how we run our portfolios.