Equity rallies are like riding an escalator. But when the market turns, the exit comes via the elevator.
This week’s sudden descent should really come as no surprise to investors. The US bull market run has looked very long in the tooth for some time. Investors have been seeking defensive areas over the summer while tech juggernauts Apple and Amazon both surged past the magical $1tn market capitalisation number.
Wall Street has also outstripped the rest of the world by a stunning margin in performance terms this year, a divergence that has worried investors in recent weeks and spurred some rotation away from US equities and towards Japan and other markets.
So, clear signs of a top were there for all to see.
The catalyst for pushing the ground-floor button has arrived in the form of stronger US data and more hawkish chatter from Federal Reserve officials. It is a combination that finally punched the 10-year Treasury yield well north of 3 per cent to its highest level since 2011, an outcome that has particularly hit tech shares — long Wall Street’s leadership group.
US equities and, in particular, fast-growing tech companies had benefited from a 10-year Treasury yield camped below 3 per cent. Lower long-term yields make stocks look attractive, an approach best summed up by the term Tina — “there is no alternative” — which was distinctly fashionable until yields started slowly climbing this year.
But they really suffered on Wednesday, with the tech-heavy Nasdaq Composite dropping 4.1 per cent, its biggest one-day decline since June 2016, and the NYSE Fang+ index down 5.6 per cent. The S&P 500 had its worst day since February, falling 3.3 per cent.
It is hardly surprising that owning US tech has been the most crowded trade for some time — these companies are growing rapidly and have been big beneficiaries of tax reform. It also reflects the allure of momentum, whereby investors stick with the winners even through the dips, akin to climbing the stairs of a market rally. The problem is that any kind of herding behaviour in markets eventually ends badly.
Higher long-dated yields means that the cash flows being generated by fast-growing stocks no longer look so rich so a reckoning must occur, as we have seen.
Indeed, one very important sector illustrates how momentum can work very harshly against a portfolio. Chipmakers, which sit at the coalface of the global supply chain, have led the sell-off for tech this week, as Sino-US tension has moved well beyond trade. The Sox (aka the Philadelphia Semiconductor index) plunged 4.5 per cent on Wednesday and has decisively broken below a key measure of momentum that has held since March 2016.
In effect, the Sox hoisted a huge red flag for tech and if we look at the Faangs (Facebook, Amazon, Apple, Netflix and Google) and Nasdaq, the message is getting through. Wednesday’s Wall Street market rout is the clearest sign yet that investors are worried about the outlook for the global economy as Sino-US relations go from bad to worse. Weaker global growth does matter for large US companies, already facing headwinds on their foreign revenues from a stronger dollar.
So, where do we go from here?
As the sell-off intensified in New York on Wednesday, one trader highlighted that when the 10-year yield was at current levels in 2011, the forward multiple on the S&P 500 was 13.1 times, whereas it now stands near 16.5 times. That leaves the market trading at quite a premium to valuations seen then.
Now, two things can help steady Wall Street and global equities. The latest US earnings season begins on Friday when JPMorgan reports, and robust results will help lower forward price-to-earnings ratios. We could also see long-term yields drop and thus moderate the pressure on equity valuations.
What is more likely is a combination of the two along with a further retreat in the market. The weaker hands will get washed out and I suspect when big tech reports later this month, momentum may well resume as cheaper stock prices and strong earnings bring out the buyers.
Bull markets die from recessions and for the US that remains a low risk at this stage of the cycle as the tailwind from tax cuts continues playing out. Although we are nearing the end of the cycle, stock market leadership tends to persist right up until the music stops — as we saw with banks and financials in 2007.
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