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Market Dominoes Keep Falling

After yesterday’s bounce, we’re seeing another bad day for the market. When I started writing this, the S&P 500 was down another 2 percent. The proximate cause here seems to be slower-than-expected revenue growth in two bellwether tech companies, Google and Amazon. They are down significantly more than the market as a whole, although the damage is widespread.

Looking at the results, I think we can start to see much of what is driving this pullback. Although a fundamental factor—the spike in longer-term interest rates—set off this recent spate of volatility, it has morphed into something general. Even as rates have dropped back, the decline has continued and worsened, indicating that something else is going on. The renewed drop today on the poor revenue growth shows what that "something else" might be.

Growth in tech companies

Over the past several years, the market has moved higher primarily on growth in large tech companies, including Google and Amazon. Prices kept moving up based on the expectation that growth could continue indefinitely. The S&P 500 is based on market capitalization (i.e., how much all of a company’s shares are worth in aggregate). So, as the companies’ share prices continued to rise, they became a larger part of the index. When they rose further, they pushed the index even higher.

This trend was great on the ride up, but now we are starting to see the flip side. As these companies are still very large parts of the indices, when they decline, they have a disproportionate effect on the way down. The recent substantial declines look to be the result of a couple of companies dragging the indices down because of their size.

That’s not to say large tech is the only issue in the pullback. But it does seem to have exacerbated the problem. It also suggests that while the damage is real, it may not be as bad at a systemic level as the pull down in the indices would suggest. The flip side is also true, of course, as it means the run-up was not as good as it looked either.

Passive investing trend

A related but separate issue is the trend toward passive investing in recent years. Investors increasingly have just put money in the indices, regardless of pricing, on the theory that matching the index was the best possible course. What this strategy did in effect, however, was drive the buying of index stocks. The largest stocks drew the most buying, which pushed those prices up (again with the largest stocks getting the most benefit).

Both of these factors support the idea that the market continues to search for a supportable level and even support the unusual daily volatility we have seen. They also indicate that volatility is likely to continue until these excesses are worked out—or until buyers show up to start buying the indices and the tech companies again. That could be a while, which raises the risks this downturn could be deeper and longer than earlier ones.

The technical factors

There are also some worrying technical factors. The S&P 500 broke the 200-day moving average several days ago, which is when I start to pay attention. I don’t worry then because more than two-thirds of the time a break of that trend line has reversed. Now, though, the index looks like it could break through the 400-day trend line, which is a much better indicator of future trouble. We could, therefore, see an even deeper decline over the next several weeks.

Still normal volatility

That said, if we are going to have this kind of correction—and that is what it is, nothing worse at this point—now is the time to have it. With economic growth still solid and companies still growing their sales and earnings, sound fundamentals should help keep price adjustments rational. Right now, as scary as the declines have been, so far we see a normal, rational adjustment. The average year sees a decline of 14 percent. Right now (as of this writing), we are down less than 10 percent. This is normal volatility and a normal price adjustment. It could get worse and may well do so, but it would still be normal.

So, what should we do?

For a well-constructed portfolio, designed around your personal time frame, the answer is probably nothing. Since this is normal volatility, your portfolio was designed to ride it out. If you are not comfortable, now is a great time to consider why and to make any changes needed so you are. My group has been working with advisors to help investors do just that. It’s time to think—not to panic.

Big picture

It is a scary time, and it could get scarier. It is, however, normal and just part of what allows stock markets to offer the returns they do over time. Remain calm and carry on.


Authored by Brad McMillan, CFA®, CAIA, MAI, managing principal, chief investment officer, at Commonwealth Financial Network®.

© 2018 Commonwealth Financial Network®

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