Kicking the Bull Market’s Tires
Since the beginning of the year, we have been letting readers know that we expected greater volatility in 2018. Such calm predictions are easy to make before the volatility has arrived. Once it has arrived, of course, it feels much more alarming than it did when it was just a twinkle in analysts’ eyes.
As usual, the question is whether a correction is going to accelerate into bear-market territory by clocking a greater-than-20% decline. The initial decline from the January 26 peak of the S&P 500 was 11.8%, and the second decline, from March 13 to this writing, did not reach earlier lows. The tech-heavy NASDAQ index’ initial decline was 11.7%; it made a new high on March 13, and as of this writing has declined 9.6% from that high. Notably, while the S&P 500 touched its 200-day moving average, the NASDAQ has not yet done so.
Source: Bloomberg
The ongoing outcry about Facebook’s [NASDAQ: FB] data privacy issues is not dying down. Indeed, in the press, articles on the subject are reaching new levels of thoughtfulness about the cultural shift that has favored a casual attitude among consumers about the extent of data collection by big tech and the uses to which those data are put. A return to the status quo is unlikely — the status quo that existed before before the arrival of social media and other dominant online advertising and e-commerce platforms. Still, a shift of public and regulatory opinion that crimps the giant platforms’ growth prospects is not impossible, and if that gathers steam, they could have further downside ahead.
As we wrote last week, we are still bullish on many tech themes beyond these giant consumer-facing platforms, including networking; videogames; hardware and storage; semiconductors; creative, collaborative, and analytical software; cloud services; cybersecurity; and financial technology. However, the stocks of these companies are being punished as well in the general decline, and should the decline continue, they will likely be punished more. While some tech stocks may soon represent attractive bargains, and while the long-term importance of information technology will only continue to grow, tech stocks have abdicated their market leadership. In the absence of clear leadership, the market is bound to feel like an uncertain no-man’s land. We currently hold large amounts of cash for clients, so that we can take advantage of the decline, particularly if it progresses further.
As the market splutters and complains, here’s what we think is going on under the hood
Two Basic Shifts
What follows is obvious, but sometimes a clear summary of the obvious is useful, especially in the midst of some serious market turbulence.
There are two basic and significant changes underway as the long post-recession bull market ages, matures, and begins to approach its final highs.
First, central banks around the world, whose radical policies kept the global financial system from crashing and burning in 2008, are either actively moving towards more normal policy, or letting everyone know that such normalization will be coming soon.
Those radical policies — ultra-low rates, quantitative easing, and so on — have suppressed market volatility and boosted asset valuation performs for nine years. As normality approaches, volatility will increase, and asset prices will be under pressure. The normalization process thus far has been very moderately paced and well-communicated, without surprises or shocks. Hopefully, that pattern continues.
Second, the world is finally experiencing a coordinated rise in economic growth. Growth is positive and accelerating in all the major economies and most others in the world with the exception of a few political basket cases such as Venezuela. The era of low growth which was so politically troublesome in many developed countries is drawing to a close.
Therefore the market is caught in a tug-of-war between shrinking valuations, and rising earnings. Ultimately, we continue to believe, the rising earnings will win out, and the bull market will rise to new highs before events occur that finally bring it to an end. (Those will be credit events — for example, an inverted yield curve — because the bull market has been and remains fundamentally credit-driven. We are attentive to early developments of excess in some credit markets, for example, pensions pursuing yields by moving to more aggressive leveraged bond funds.
What Those Shifts Mean For Investors
Those obvious truths have several ramifications for investors.
One: Rising volatility means that events the market used to shrug off in recent years will now be able to trouble it much more. Events such as the FB data debacle, or an outbreak of political instability within a country, or the threat of hostilities between enemy nations, or an unexpected central bank policy announcement, or a prospective trade war, will no longer be mere blips. They will have the ability to quickly cause significant anxiety and market declines.
Two: Rising volatility and shrinking valuations will disproportionately affect the market’s high-flying, expensive growth stocks. More reasonably priced stocks, and stocks with what Mohamed El Erian describes as “a deep, dedicated investor base,” will fare better. Declines like the current one will likely culminate with the expensive growth stocks getting “taken to the woodshed.”
Three: Volatility, and event anxiety among market participants that is not so easily assuaged anymore, will mean that technical factors will become increasingly significant. That is another way of saying that herd behavior in selling will become worse, driven largely by automated trading programs. The market will increasingly be a viral robotic “echo chamber” on bad days.
Investment implications: The economic fundamentals underlying the U.S. and many global stock markets remain robust. However, the age of the present bull market, and the slow-and-steady withdrawal of extraordinary central bank support, will create significant volatility — volatility which may create significant declines. Normal and healthy declines at the best of times can be 10–15%, and even more significant declines are possible under the market conditions now developing. In the longer run, until we see signs of a fundamental deterioration of financial, economic, and credit conditions, we will continue to view declines as opportunities to buy stocks at attractive valuations.
