When the stock selloff began in earnest at the start of this month, it looked like a simple loss of momentum for a bunch of high-growth disruptive stocks that had risen too fast. Now it is morphing into broader concerns about the economy, and investors are factoring in less chance of the Federal Reserve raising interest rates aggressively next year.
The question on which investors need to take a stand: Is this a healthy correction in a bull market with further to run, a reset lower in belated recognition of this year’s geopolitical risks, or the start of a new bear market ahead of recession as soon as next year?
A healthy correction is a classic case of the stock market holding a sale. As market pessimism feeds on itself, take the advice of the father of value investing, Benjamin Graham, and buy from the pessimists. This is usually the right advice in a big market fall, although since the fall has left the market only about where it started the year, it isn’t—yet—that big.
Market moves tell us what the market is anticipating. Since the stock fall began in earnest on Oct. 3 the message has changed to suggest growing concern about both geopolitics and the economy. Investors who accept the market narrative will worry about slower growth or higher risk of recession justifying lower prices. Consider:
First, almost all major stock markets have fallen as much or more than the U.S., in dollar terms, as Italian politics roiled Europe, trade concerns hung over China, and indebted emerging markets continued to suffer from the strong dollar. This isn’t merely a correction in highflying U.S. technology stocks, as it seemed at first.
Second, sectors most exposed to economic growth have been hit hardest, while defensive sectors have withstood the selloff. S&P 500 energy, materials, industrials, technology, communication services and consumer discretionary sectors all lost more than 10% from Oct. 3 to Monday’s close, and financials were close behind. By contrast, the defensive utilities, consumer staples and real estate were slightly up. Investors have switched from betting on growth to buying safety—reflected also in rising Treasury prices (so lower yields), as the stock selloff continued.
Third, growth-sensitive commodities have tumbled, with U.S. oil prices down 12% and industrial metals off 5%. Weaker U.S. and global growth would mean less demand for such basics, and markets are pricing that in.
Fourth, junk bonds have joined the selloff. The extra yield above Treasurys demanded by investors to cover the risk of U.S. junk bonds has risen more than half a percentage point since hitting a 10-year low of 3.16 points on Oct. 3, according to ICE’s benchmark index. The scale of the rise is similar to that amid February’s volatility but takes the actual yield to the highest since shortly after President Trump’s election, demonstrating concern beyond just a rotation out of growth stocks.
Finally, there is always the risk that the selloff becomes self-fulfilling. Falling shares make people feel poorer, and they tend to spend less as a result; similarly, companies whose shares are tumbling are less likely to invest in new projects. Goldman Sachs quantifies this by including stocks in its financial-conditions index designed to provide a broader measure than interest rates of the effect of tight money on economic growth. The index has tightened the most this month since the China panic in early 2016, thanks mainly to the stock selloff, implying a weaker economic outlook.
“What we’ve seen since the start of October would shave about half a percentage point off [GDP] growth,” says Sven Jari Stehn, senior global economist at Goldman, assuming it lasts.
I’m inclined toward the view that this is a healthy correction, as I started out thinking that this year’s rapid rise in the FANGs and other acronym stocks was overdone. A rotation away from overpriced tech into cheaper companies makes sense and is still under way, as Monday’s 6% drop in Amazon shares showed. It doesn’t mean the economy is weak.
True, Friday’s GDP figures weren’t as good as the overall 3.5% growth suggested. True also that there is still no sign of accelerating inflation, raising doubts about the pass-through from low unemployment to higher wages. But the bull market raged for the past nine years, while the U.S. economy produced annualized growth of only 2.3% a year. Even if this year’s tax-cut-driven growth were to halve, it doesn’t mean recession or the bear market that almost always accompanies an economic slump.
The inevitable recession might come next year, or later. But aside from a historically unremarkable stock market fall, little else has changed from a month ago. Investors who have turned from optimists to pessimists may get more fearful yet, but so long as they keep selling, this is an opportunity for anyone who remains positive to pick up solid companies for less.
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