Over the past month, global stock markets have been weak even as economic data is encouraging. This turbulence follows what was a stable year for stocks, as investors seemed to shrug off negative news in 2017. What is different this time? Why are markets so turbulent?
Several forces are at work, and we highlight what we see as the reasons below.
It may be reassuring to know we don’t consider the reasons surprising. They reflect the natural ebb-and-flow of investment cycles and investor spirits. Of course, the frustration is that no one can predict WHEN events occur. Still, the encouraging news is that with a disciplined approach we can recognize their occurrence and position portfolios accordingly.
Big Tech Stocks Break Down
One of the most obvious reasons for recent market weakness is the hit a few tech stocks have taken. Since March 12, the popular “FAANG” stocks are down 8%-14% (as of March 31), off what for most were all-time highs. Their weakness helped bring the overall market down about 5% during this period.
These tech names fell for various reasons—data privacy issues, threats of tighter regulation, operational challenges, and fatalities from self-driving cars. These are legitimate challenges for these companies, although they are not likely to be game-changers alone.
But the challenges themselves are not the key point. The important points are that:
- Many of these popular tech stocks are priced for perfection and have little room for error. When they stumble, it is hard to “find a floor” since prices (and expectations) are high.
- Just five stocks (Alphabet/Google, Amazon, Apple, Facebook, and Microsoft) account for over 12% of the TOTAL MARKET VALUE of the largest 1000 stocks in the US, as we’ve discussed before. This incredible concentration brings a magnified impact on the market, both positive and negative.
- This narrow group warps the returns of many popular passive index funds, given the stocks’ large weighting. Ironically, investors in such index funds are often taking bigger risk than they assume.
For context, tech stocks last saw this phenomenon over 15 years ago (Exhibit 1). By 2000, tech stocks had swelled to over 30% of the total market value of the largest 1000 US stocks. They disproportionately drove the market upwards. When the bubble burst, they shrunk to less than 15%, and held those levels for almost a decade. Currently, tech stocks are now over 20%. (Note: international and emerging markets currently show the same characteristics; this is not unique to the US.)
Importantly, we are not saying that we are seeing another “tech bubble” although several tech stocks do have rich valuations. Our point is that the five FAANG stocks account for about HALF of overall tech market values, representing concentration risk. The FAANGs largely account for all of the growth in value of the tech sector over the past 18 months.
Exhibit 1: Weighting of Tech Stocks
Source: Bloomberg and CornerCap
We currently own Apple in our Composite Large Cap strategy (we also owned Google in 2016)—and Facebook is now becoming more attractively ranked in our research system after its slide—but we generally have not participated in the Big Tech rally. We see disproportionate risk in owning many of these stocks.
Getting Too Complacent
Underneath the fall in tech is a deeper issue, in our view. Investors in 2017 benefited from a relatively benign period of low volatility in stock prices, driven by low interest rates, predictable economic growth, and low risk of inflation.
A look at volatility over the past 65+ years shows recent activity in context (Exhibit 2). For 2017, annual volatility was the second lowest in history. For the first quarter of 2018, volatility surged and was among the top 12% for all quarters since 1951.
Exhibit 2: An Historical Look at Volatility
Source: Bloomberg and CornerCap
This quarter, we saw a rapid shift in extremes, which of course catches investors off guard. The reality, however, is that these levels of volatility are within historical norms. We believe we are simply seeing regression to the mean happen, as we don’t expect extremes to persist indefinitely.
It would be unreasonable to expect the historically low volatility of 2017 to hold for long periods. We don’t know how long this period of higher volatility will last either, but we would expect overall volatility to reflect historical norms over long periods.
We argue that this volatility in and of itself should not alarm you in a properly diversified portfolio that reflects your long-term risk profile. We work carefully to build customized client portfolios to accommodate interim volatility while preserving long-term client objectives.
Risk that Politics Could Spoil Economic Growth
The third reason for recent weakness and volatility is harder to measure. It involves political decisions relative to economic growth.
There’s a common saying that economic expansions “don’t die of old age; they die of policy mistakes, asset bubbles, or outside shocks”. Current economic growth has been on the weaker side but certainly strong enough and potentially improving.
The mounting risk of an “irrational” trade war between the US and China has ignited investor fears that policy mistakes could hurt growth, thereby ending one of the longest runs of economic expansion in history. Escalation of tariffs and protectionism could restrict trade and raise prices (not just between the US and China), slowing global economic growth.
For portfolio management, it is impossible to predict the outcome of political events. Instead, we believe a diversified portfolio that balances your near-term needs with long-term goals can accommodate the market swings (up and down) of unpredictable events.
Our Opinion (For What It’s Worth)
Protectionism is certainly an unpredictable wildcard, but we see less probability of recession at this point. If anything, the increased stimulus from recent legislation (the new tax bill and the infrastructure spending plan) should help boost growth, putting a greater risk of inflation rather than deflation. It therefore makes sense that we have seen weakness in yield-oriented stocks (like utilities, staples and real estate) and fixed income.
Ultimately, we suspect neither the US or China truly wants a deep trade war. That said, difficult decisions are ahead and will take time to resolve. Important issues have been left unaddressed over the past 15 years (e.g., China’s violation of WTO agreements; its abuse of intellectual property rights), and the US’s initial strategy (higher tariffs, unilateral decisions) has arguably lacked discipline. We are hopeful that negotiations will find balance and stability.
Each of these three reasons—tech concentration, swings in volatility, and threat of trade wars—illustrates how markets can appear irrational or unpredictable in the short term. Over time, however, we believe market anomalies smooth out and neutralize the extremes, helping to make portfolio outcomes more predictable and stable.
 FAANG is an acronym developed over the past few years to represent the popular tech stocks Facebook, Apple, Amazon, Netflix and Google (now Alphabet, the parent company), which are widely held by investors. It does not include Microsoft and Tesla, which are/were also strong performers at various points, and also broadly held.
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