Correction, Rotation or Revolution

For those of you who have spent some time with me over the years, you know how much disdain I have for the phrase “market correction.” At its simplest level, this juvenile comment implies the market is mispriced and there is a “more accurate” price lower than the present or prior level attained not long ago. From our perch the market never truly corrects, it is always reflecting the current price for two willing parties, the price is right today and will be right tomorrow or two weeks from now even though it will be at different levels each and every time. Enough quibbling there, we must first acknowledge that the market is prone to drawdowns, or meaningful declines, in fact they are fairly common. Going back the last 40 years, the average intra-year decline averages about 14% from peak to trough and we likely witness 1-2 of these selloffs of 5-10% per year. Last year we witnessed a decline of about 10% between mid-July and late October, when worries related to where interest rates were headed weighed on investors. 2022 was itself a year of tough sledding with the S&P 500 Index entering bear territory by June and then retesting lows again in October. Ending the year down over 18%, bonds were only marginally better though registering their worst year in decades down about 13% when looking at the Bloomberg Agg.

At the time of this writing the Nasdaq composite is off about 8% from all-time high touched on June 11th, ironically enough that was the day we saw the June CPI data that signaled further progress had been made on reigning in inflation and opening the door for the Fed to start easing this year, likely at September’s meeting.  The “more diversified” S&P 500 is off about 4.3% from its peak which registered a few days later on July 16th. I put in quotation “more diversified,” as of late there has been higher correlation between the S&P 500 & the Nasdaq composite as the large technology stocks make up a greater weighting of the more widely followed S&P than had been the case in the past. For those of you watching at home, the good old Dow Jones Industrial Average, a misnomer if there ever was one, is down a more palatable 3.7%.

So, what gives… It’s likely a combination of factors that have contributed to the pressure on tech stocks and the market on a whole, but much like with an iceberg, sometimes it’s important to look underneath the surface. Let’s dive in.

As of the close on July 24th, just three sectors are down on the month, information technology, communication services and consumer discretionary, with only communication services down approximately .50% through Tuesday’s close. The other 8 sectors, yes I am begrudgingly including the miniscule real estate sector, which happens to be up the most in July at just over 5.5%. This should be somewhat comforting in that a more painful selloff usually results in most if not all sectors logging negative returns. It’s not so say it can’t get worse from here, where there could be some spillover effect but having a diversified portfolio would have meant there has been some opportunity to offset some of the not so magnificent performance for that handful of stocks that have been heading up and to the right seemingly endlessly since the Fall of 2022.

Three factors seem to be at play, surely related in some way.

• Valuations and expectations: Stock performance is as much about results as it is about investor assumptions in the short term. Longer-term fundamentals are far more important and will be reflected in one’s performance, see Graham’s “weighing machine” but that requires patience, something we as a society struggle to understand or accept. In their great book, Expectations Investing by Michael Mauboussin and Alfred Rapport, the authors identify a number of factors for their readers to improve their investing results. Perhaps the most salient one relates to the concept of revisions.

“Investors do not earn superior returns on stocks that are priced to fully reflect future performance… The only way for an investor to achieve superior returns is to correctly anticipate meaningful differences between current and future expectations.”

This may seem to suggest something representing market timing, but that is not what the authors are suggesting, instead their comments are meant to serve as a bit of a wake-up call regarding consensus or herd behavior. Seemingly daily, my partners and I have been fielding calls related to AI and in particular one semiconductor stock for the last 6 months. In past experiences when certain pockets of the market had captured so much investor attention it generally signaled a top vs. newfound revelation leading to vast profits. See crypto, marijuana, meme stocks, as recent examples. It’s not to say that there are not wonderful companies, producing great products and services, just that perhaps that is more than reflected in their prices. Being priced for perfection ends up being a curse when you are unable to deliver on those lofty expectations. With large cap growth stocks trading at a 40 P/E there is little margin for error as it seems they very well be priced to fully reflect the future.

On the opposite end of the spectrum, there have been large swaths of the market, i.e., value, small cap stocks or overseas companies where recession level sentiment has weighed on performance recently. As industry insiders know, performance drives the flow of funds which further push up prices, these virtuous cycles can last longer periods of time and make you forget about anything else out there. After offering less stellar results for the last decade, investors had soured on anything that was not tech or tech adjacent and the results seemed to suggest that was a wise move to pursue when you considered the following annualized returns for the last 10 years.

• S&P 500: 12.85%
• Russell 1000 Value: 8.23%
• Russell 2000: 7.00%
• MSCI EAFE: 4.54%

It is clear that investor sentiment around these stocks has meant they have far less demanding valuations and don’t need everything to break right for performance to improve, in fact it may mean things don’t even require anything all that great to occur, but just for things to not get any worse. When the Fed’s tightening cycle began in March 2022, investors initially worried about the impact higher rates would have on “long duration” stocks, which historically meant smaller growth plays in technology and healthcare, many of those stocks remain well below their November 2021 peaks to this very day, lest we forget even those large tech behemoths benefiting from some secular tailwinds experienced a punishing 2022 when the Nasdaq shed 32%, in fact based on today’s close the index is up only 7% from the 16,212 level back on November 22, 2021. Given the lack of enthusiasm, the combination of a resilient economy, supported by lower borrowing costs, just may create a healthy backdrop for these unloved areas.

• Seasonal effects & earnings season: The summer months traditionally mean less trading volume and quieter capital markets when it comes to originations for both debt and equity new issues. The result tends to mean wider bid/ask spreads and with that additional volatility. This is surely one of the reasons the “sell in May and go away” idiom hasn’t itself been retired even though the data suggest the strategy is no better than throwing darts at a board. Given how closely followed earnings season has become, or other events like Fed rate announcements or data releases like CPI or the BLS’ Non-Farm Payroll reports, it stands to reason investor reactions themselves have been more pronounced and that’s further augmented by market structure, whether we are talking about zero-dated options, risk parity strategies or the more recently discussed dispersion trade. In theory, investors make rational decisions to maximize their self-interest, but we know that market participants are humans, whether directly or indirectly in the form of algorithms and are greatly influenced by emotions. In fact, our financial temperaments are often as volatile as the markets we monitor and much like the chicken and the egg debate we’ll never come up with a clear understanding of what came first. Our fixation on these very data points then may result in extrapolating future results, so much so that a small miss or cautious outlook today means shedding billions in market cap in a matter of minutes or hours. The opposite is true as well, when a company finds itself adding the equivalent to a Fortune 500 company to its already massive market capitalization. In the end, the confluence of forces (time and news flow) here may result in some strange market phenomena taking place when we are headed to the beach or stuck at an airport.
• Politics and partisanship: We are reticent to spend too much time discussing politics as the wise bit of advice to avoid the topic, along with religion, is especially apropos today. Of course, we have opinions and interests, but rather than offend 50% of our clients we’ll keep that to ourselves. It is safe to assume that those with strong ideological views have been on a rollercoaster for the last few weeks. A terrible debate performance, a near assassination and a decision to decline to run for a second term are things we haven’t experienced ever or at least dating back to the 1960s, when nearly all of those who are reading this piece were yet to start their investing journey or weren’t alive for that matter. The election outcome itself is likely a coin toss at this point, as is often the case here in the US, but as traders and speculators try to game out the winners and losers, we have witnessed some significant market reactions in the last few weeks. Both candidates seem inclined to see lower interest rates, though for different reasons, while their approach to foreign policy are drastically different. A troubling focus on populist ideas shared by those on the far right or extreme left are net negatives for the current economic model and markets as increasing deficits, less global trade and perhaps rising geopolitical tensions would serve to undermine some of the positives we have seen in the post War era. Populism, also known as socialism, has hardly been a successful endeavor as it serves to encourage mediocrity and disincentivizes some of the entrepreneurial or risk-taking animal spirits which have made our Nation great, in the past, present and future. Politics will remain a focus for the next 3+ months, and we expect to hear ideas that seem extreme, accusations with and without merit and a fair share of ugliness from both parties. When all is said and done my sense is that the policies that will actually be enacted by the next President and Congress are likely to have a modest impact on the economy and markets over the coming months and likely years. It will be businesses whose ability to be resilient and adaptive that make our markets the best in the world even though we are prone to occasional bouts of madness.

Sources: Bloomberg, Schwab & Co, FMR Co, WSJ, Wall Street Journal