- Technology stocks have done very well this year but have run into some resistance.
- After flirting with Energy and Financial Services, the market has settled on Health Care/Biotechnology as the new leadership group.
- The Federal Reserve seems to want to reign in excess liquidity even as recent economic measures have been on the weak side.
- A reduction in liquidity after a strong run up is the kind of thing that often leads to 5-8% corrections.
- There is an outside chance the next correction could be trigger a financial “accident” through computer driven sell programs.
The Next Correction
I’m starting to sense that the next broad stock market correction is near. If I am right, it will be in the 5-8% range. My reasoning is as follows: technology stocks have led the market over the last few years. Tech stocks benefit from low interest rates in that since they are expected to grow earnings at greater than market average rates, the present value of those future earnings is worth more. In fact, the market views some of the best known tech stocks like Amazon, Apple, Facebook, Alphabet (Google), and Microsoft almost as utilities in that they have a well-defined niche which helps them generate a high and growing stream of cash that may help to dampen the effects of a recession. Yet it would appear that investors have pushed their prices up against the limits of their comfort zone. Perhaps it was Amazon and Alphabet both reaching $1000 per share, but in any case investors seem to be saying lately that if the market is to move higher, other sector will have to supply the lift. Financial Services and Energy tried and failed. Financial stocks can’t rally with interest rates low and the yield curve flattening. Energy stocks can’t rally with production rising more than demand. Last week, however, health care and biotech stocks really surged. They share with technology a growth bias and a relative insensitivity to overall economic growth. See Chart 1.
The bottom line is that while health care may lead the market in the near term, stock prices overall might have to pull back a bit to entice more broad-based buying. Investors did not take the Federal Reserve at its word after the last rate hike when they gave details on how they planned to gradually stop supporting the bond market with repurchases. I believe that is a mistake. I am not concerned about a 5-8% correction because statistically that kind of thing happens at least once a year. My worry is that a run of the mill sell-off might be exacerbated by computer-based sell programs designed to automatically protect portfolios from rising volatility[i].
So while I don’t see an economic justification for a double-digit decline in stocks in the near term, volatility-based automated trading systems are a reason that we may have one anyway. I would re-iterate that this would be a black swan; a normal 5-8% pullback is far more likely. Investors have been lulled into a false sense of security by almost record low volatility, while the Federal Reserve seems determined to begin draining the market of excess liquidity. A tighter Fed is definitely NOT priced in, so at some point that could cause some turbulence. A little extra caution may be in order.
[i] Some of you might be familiar with the concept of “risk parity”. This strategy aims to offset one type of volatility with another. For example, for stocks the biggest risk is equity or economic risk, in other words, that the growth of the economy and therefor corporate profits will disappoint. For investment grade bonds the biggest risk is interest rate risk, or the risk that bond prices will decline as interest rates rise. Under most circumstances, a slowing economy leads to lower interest rates. Therefore, what hurts stock prices might actually support bond prices. The reverse is also true.
Risk parity holds that if we believe bonds are half as volatile as stocks and that long term government bonds move in the opposite direction as stocks, then a 2/3 long government, 1/3 stock portfolio might minimize volatility yet still offer an attractive return. The problem comes in if stocks begin to decline and bonds do not exhibit the negative correlation we expected. In that scenario, our bond gains would not offset enough of the loss from stocks. As stocks fall and their volatility relative to bonds rises, risk parity funds would have to sell stocks in order to find a ratio where bond gains and stock losses were back in proportion. Since, much of that selling is computer automated, you can easily see how selling could beget more selling, much as happened with “portfolio insurance” back in October 1987.
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