On a weekly basis, at least one of the main market averages hits another all-time high. But the bears continue to expect a correction. Will they ever be right?
Sure, but playing for a pullback is a losing proposition most of the time. You may get it right eventually, but the opportunity cost of staying on the sidelines can be, well, costly, as the bears are discovering this month.
A much better way to prepare for the inevitable next market correction is simply to reduce your risk by adjusting your portfolio. That might mean trimming back your more aggressive holdings while moving into more conservative stocks and funds. Make no mistake, you will still lose money in a downturn, just not as much.
Professional money managers adjust portfolio risk this way all the time. It has proven to be a sound principal and one that I would advise for those who may be getting a little nervous at the markets’ elevated levels.
The bears point to the deterioration of breath (the number of advancing versus declining stocks) as another sign of a weakening market. One day this week, for example, the FANG stocks accounted for more than 25% of the overall gains in the S&P 500 Index. When four or five stocks are carrying the entire market, there is some cause for concern.
Underneath the averages, many of the high-flying tech and new era stocks have seen massive damage. As readers know, commodity stocks, meme, favorites, and crypto currencies have also been decimated. Bears are also pointing to the recent damage within the biotech sector, as well as to the Russell 2000 Index of small cap stocks. Both areas have seen intense selling over the last two weeks. Historically, if these sectors continue to trend lower there is a high probability that the overall market will follow them down.
Another reason for nervousness is the continued weakness in bond yields. The U.S. Treasury Ten-Year bond is hovering between 1.30%-1.35%. Confusion reigns on why interest rates remain this low. If the economy is expected to continue growing (6.5% this year) and inflation is a worry, interest rates should be higher.
The bears offer one explanation. The economy, they believe, will have reached its peak growth rate this quarter. From here forward, the growth rate for both the economy and corporate earnings will slow. Bond yields may be telling us that both the economists and equity strategists are too optimistic when it comes to the future growth rate of the economy.
What is not widely understood is that investors are more concerned with the changes in the growth rate of the economy (or an individual company), rather than the growth rate itself. They will pay up for a perceived uptick in the rate of change in growth but are less impressed (or downright negative) if the growth rate remains the same or begins to slow. Why? Because the present rate of GDP growth (6.5% for 2021) is already reflected in the price level of the market. Only a change in growth will impact future price action.
This week we received the latest inflation data for June 2021. Both the Consumer Price Index (CPI) and the Producer Price Index (PPI) were much higher than expected, and yet interest rates and the stock market barely budged. It appears that most investors have accepted the Fed’s arguments that higher inflation, which they expect to persist through the remainder of the year, is temporary.
Stocks are fully priced, in my opinion, and overpriced in some areas. The bears are right on that score, but that doesn’t mean stocks can’t continue to go higher. Remember that the constant rotation we are experiencing between sectors is a self-correcting mechanism. Large cap growth stocks spent several months doing nothing, or going down, while value stocks gained in price. Small caps and biotech stocks have been correcting lately, while tech shares lead the market higher.
There is no reason why this rotation game can’t continue. In which case, the risk of a large-scale price correction is less likely to occur. Investors should stay invested until something material causes a change in the market’s dynamics. Two unknowns I worry about most are a major change in the Fed’s monetary stance, or another disruption caused by the Delta variant of COVID-19.