Market selloffs have sometimes started with simple narratives, particularly when one previously-believed story evolves into another. This causes investors to recalibrate their assumptions. From a fundamental standpoint, economies don’t often change over the course of a week. Rather, it can be a variety of puzzle pieces that reconfigure themselves, turning complacency into anxiety. (Of course, they’ve been shown to reverse course at times just as quickly.)
For perspective’s sake, the S&P 500 is down over -8% from closing highs in mid-July. What’s changed in the last few weeks?
Celebration over inflation cooling has become old news, replaced by concerns that the U.S. labor market has deteriorated faster than some expected. There is still debate whether this is indeed the case, with nonfarm payrolls still positive (albeit not to the same degree), and the unemployment rate inching higher and triggering some predictive recession models based on the speed of deterioration. Overall levels remain low, though. The bearish camp out there has argued the Fed has ‘missed the boat’ by not cutting rates in July, with the lagged effect of higher interest rates having finally tightened the economy too much during the year of pause. The Fed could choose to cut rates between meetings, but it’s not clear whether they’d want to and what kind of message this urgency would send. The more bullish camp argues that the labor picture remains decent, with some measurement issues caused by seasonality and the influx of immigration as of late that skews the statistics, and pointing to other data that show general economic strength (like above-trend GDP growth predictions this quarter).
Global shifts are occurring, seen by the dramatic sell-off in Japanese equities last night (-12%), although this may be carryover to some extent from last week’s negative U.S. results (bad days have a tendency to roll around the world). After decades of malaise and implementing market reforms as well as offering the world’s lowest interest rates creating a source of cheap carry at low interest rates, Japanese stocks saw a resurgence. Now that rates are rising and policy normalizing (QE being reduced), that story has decelerated in the 2nd-largest world stock market (albeit far smaller than the U.S. share) as trillions of dollars of carry trades are being potentially unwound or at least reset. This shift is subtle, but the amounts are meaningful globally.
There has been some weakening in selected areas of U.S. consumer spending, noted anecdotally in several key earnings reports, with the related cautiousness likely also pulling down sentiment. Again, this is a nuanced story, with a natural slowdown as pandemic stimulus has worn off, in a transition back to a ‘normal’ environment.
Questions have surfaced about the immense capital spending on artificial intelligence (AI) that has taken place in recent quarters, notably by the ‘Magnificent 7’ group. What’s less certain are the prospects for profits on these expensive investments, how long that payback will take, and who will benefit.
Valuations had become a bit rich, particularly in U.S. large cap growth (specifically in technology-related firms). If using the price-to-earnings ratio as a simple metric, earnings have been strong for Q2, but if the ratio moves beyond the market’s expected comfort level, the price numerator is the one forced to immediately adjust.
Some stock stories are perhaps not that critical by themselves but can serve to feed on other anxieties. For instance, Apple fell by nearly -10% at one point, highlighted by sales from Berkshire Hathaway, led by well-watched investor Warren Buffett. They continue to own a sizable stake in the company, and such sales to avoid higher concentrations in single stocks are not usual for them. In fact, it’s been hard to find an institutional investor more bullish on the long-term potential of the U.S. economy and stock market than Buffett.
Growth in other global segments, such as China, has remained stubbornly weak, which has frustrated investors. This has carried over to some commodity markets, like crude oil and copper. Low valuations reflect this, but don’t appear to have deteriorated significantly further—pointing to potential opportunity for the patient.
Summer can also be an unusual time for markets and is still the subject of academic research looking at seasonal tendencies. Vacations can result in lighter trading volumes, where overreactions, pockets of illiquidity, and unusual price movement can develop. That’s where the ‘Sell in May and Go Away’ adage came from, although it obviously hasn’t been consistent enough to use as an investment timing guide reliably.
After strong stock market stretches, a common pattern has been a steady fall in market volatility, with complacency kicking in. Then, price reversals downward have been more dramatic, with much more volatility on negative days than positive days. It’s worth another reminder that in the post-World War II era, the S&P 500 has typically experienced several separate -5% pullbacks in any given year, with -10% corrections roughly once every year and a half on average. Bear markets of -20% or so tended to be reserved for recessions, occurring on average once or twice per decade in line with business cycle changes. Deeper declines (like -30%) have tended to be tied to significant geopolitical or structural events of a dramatic nature—which have created far more uncertainty than recessions at the time. After the pandemic in 2020, and a recession ‘false alarm’ in 2022 along with rising interest rates, we’ve had more than our share of volatile events over the past several years, with investors tending to fear the worst right away.
Volatility can be unnerving, especially when it crops up only occasionally, but suddenly. In portfolios, warming up to fixed income has been difficult for some investors after the historic year of declines in 2022, with preferences for cash abound. However, over the past few weeks, price gains in bonds as interest rates have fallen have largely offset declines in stocks, which is indicative of their long-term diversification value.
Possibly one of the simplest and best behavioral solutions is to take an updated look at a long-term graph of the U.S. stock market over the past century or so. Dips are frequent, with a routine three steps forward-one step back type of quality, although movement has never seemed to occur on a predictable basis. Although past performance is not predictive of future results, of course, upward progress over the long haul has been the most notable feature of the historical chart.
Provided by:
Ryan M. Long, CFA
Director of Investments
FocusPoint Solutions, Inc.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment adviser.
Sources:
Ryan M. Long, CFA; Director of Investments; FocusPoint Solutions, Inc.
Bloomberg, Goldman Sachs Investment Research, Morningstar, U.S. Federal Reserve, Yahoo! Finance, FocusPoint Solutions calculations
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