The recent turbulence in the financial markets serves as a stark reminder of the inherent volatility that can quickly reshape the investment landscape. This past week was marked by dramatic stock swings, a surge in market volatility reminiscent of the early days of the COVID-19 pandemic in 2020, and currency fluctuations that caught many investors off guard. While the sharp declines in U.S. stocks on Monday, where the market shed approximately 2.5%, and Japan’s Nikkei 225 plummeted by over 12%, seemed to fade into the background by Friday, the underlying message was clear: the status quo in the investment world has shifted.
Investors received a jarring wake-up call that shattered the complacency that had settled in after months of bullish markets driven by the spectacular rise of large-cap technology stocks. A weaker-than-expected July jobs report, released on August 2nd, indicated that the economy might finally be softening after an extended period of strength. This, combined with an uptick in Japan’s interest rates—still ultralow but higher than before—triggered the unwinding of the popular leveraged “carry trade,” a strategy that had propped up numerous stocks, currencies, and other assets over recent years.
Adding to the uncertainty, skepticism is growing around whether artificial intelligence will truly deliver on the lofty promises implied by the near-vertical rise in market valuations of the largest technology companies this year. The specter of a contentious U.S. election season, coupled with escalating global turmoil, is further stoking fears that the markets could face more significant challenges ahead.
Despite a recovery that saw U.S. stocks regain nearly all the ground lost earlier in the week, the volatility suggests that the turmoil may not be over. This volatile environment presents a compelling case for investors to adopt a more defensive approach, diversifying their portfolios away from the high-flying technology stocks—the so-called “Magnificent Seven”—and towards less richly valued sectors.
Todd Walsh, CEO and chief technical analyst at Alpha Cubed Investments, characterized the past week’s developments as “a perfect storm of normalization.” He emphasized that investors should be reminded that the economy is bound to slow down eventually, and it’s risky to concentrate portfolios too heavily in just a few stocks, particularly in the tech and AI sectors. Max Wasserman, co-founder and senior portfolio manager at Miramar Capital, echoed this sentiment, advising investors to take a step back from the day-to-day market fluctuations and focus on their long-term investment strategies. The critical question, he says, is whether one is looking to make quick trades or investing for the long haul.
For those focused on short-term trades, the recent market conditions have provided ample opportunities. The beginning of August was marked by unsettling economic news: the Institute for Supply Management reported a sharp contraction in U.S. manufacturing, with its index falling to 46.8 in July, well below expectations. Simultaneously, a surprise jump in weekly jobless claims set off alarm bells, leading to a nearly 500-point drop in the Dow Jones Industrial Average and a sharp decline in bond yields as investors sought the safety of bonds.
The situation deteriorated further when the U.S. government reported that only 114,000 new jobs were added to nonfarm payrolls in July, far below the expected figures. This spurred further declines, with the Dow falling another 600 points, and some economists began calling for an emergency interest rate cut by the Federal Reserve, which is already anticipated to lower rates at its September meeting.
As the week progressed, market sentiment seesawed. The news that Warren Buffett’s Berkshire Hathaway had offloaded a significant portion of its stake in Apple—its largest equity holding and one of the “Magnificent Seven” tech stocks—added to the unease. Meanwhile, Japan’s benchmark stock index plunged following the aforementioned rate hike, prompting investors who had borrowed in yen to buy U.S. tech stocks and other assets to quickly unwind those trades.
The result was a steep drop in major indices: by Monday’s lows, the Dow had lost over 2,300 points in just three days, the S&P 500 had fallen by 6%, and the Nasdaq Composite had entered correction territory with a pullback of over 10% from its recent highs. Even small-cap stocks, which had rallied in July as part of a rotation into sectors expected to benefit from lower interest rates, saw significant declines.
The fear in the market was palpable. The Cboe Volatility Index (VIX), often referred to as the market’s “fear gauge,” surged from the teens to over 65, its highest level in years. The 10-year Treasury yield tumbled from around 4.1% to 3.67% as investors flocked to the safety of bonds, driving prices up and yields down. Even traditionally safe-haven assets like gold saw declines, and cryptocurrencies like Bitcoin were hit hard, with the latter losing 8% in value.
However, by midweek, sentiment had turned again. The stock market rallied on Tuesday, experienced volatility on Wednesday, and surged again on Thursday after a drop in weekly unemployment claims suggested that the job market and the broader economy might not be weakening as much as feared. By the end of the week, bond yields had almost returned to 4%, and the VIX had retreated to less alarming levels in the low 20s.
So, what does this mean for investors? On one hand, long-term investors shouldn’t be overly concerned by a week of volatility or the market’s churning. Despite the recent turmoil, the S&P 500 and Nasdaq remain up over 11% for the year, and recent data supports some existing trends, such as a cooling labor market and a shift from the most expensive technology stocks to more cyclical sectors like energy, financials, industrials, and dividend-paying utility stocks and consumer staples. This trend could accelerate, which would be a welcome development for those seeking broader market participation.
On the other hand, the severity of the recent price swings in various asset classes highlights potential broader changes on the horizon and reveals an underlying fragility in the markets. Investors who have focused primarily on AI-driven tech stocks might want to reconsider their strategies. Bill Sterling, global strategist at GW&K Investment Management, advises against chasing recent winners, noting that diversification is crucial for long-term portfolios. He suggests looking beyond large-cap tech to sectors like energy, industrials, and financials, where opportunities may be more abundant.
James Ragan, director of wealth management research at D.A. Davidson, also recommends taking some profits in tech stocks, rebalancing portfolios, trimming overweight positions, and adding to underperformers. Todd Walsh of Alpha Cubed believes that value stocks, particularly dividend payers within the “Forgotten 493” of the S&P 500, may outperform in the coming months. Brad Long, managing partner and chief investment officer at Fiducient Advisors, sees high-yielding utility stocks as a compelling alternative to the “Magnificent Seven” tech stocks.
While tech valuations may not be as inflated as during the dot-com bubble of the late 1990s and early 2000s, or even earlier this year, the market’s largest companies are still expensive. The Roundhill Magnificent Seven exchange-traded fund currently trades at around 32 times earnings estimates, a significant premium that might have been justified when growth was scarce outside of the tech sector. However, earnings growth is expected to broaden across the market, with the equal-weighted S&P 500 index forecasted to see a 5% increase this year and a 14% rise in 2025, following a modest 1% gain in 2023. The equal-weighted index trades at 18 times 2024 earnings estimates, compared to a price-to-earnings ratio of 22 for the market-cap-weighted S&P 500.
Valuations for smaller and midsize stocks are even more attractive, with the S&P SmallCap 600 and S&P MidCap 400 indexes trading at just 16 times 2024 earnings estimates. These stocks could benefit significantly if the Federal Reserve begins to cut rates, as many of these companies carry floating rate debt, which would become less burdensome with lower interest rates.
The market’s recent volatility has also created more attractive entry points for some of the Magnificent Seven stocks, such as Microsoft and Nvidia. According to Phil Blancato, chief market strategist at Osaic, there may be more buying opportunities ahead if volatility persists, which is likely given that August and September are historically weak months for the market. He suggests that investors should take advantage of sell-offs in high-quality companies.
In conclusion, while the markets have calmed somewhat after the August turmoil, this period of volatility should not be quickly forgotten. Investors need to remain vigilant and attuned to the signals being sent by both stocks and bonds about the potential macroeconomic and market changes ahead. Diversifying portfolios, being cautious of overvalued tech stocks, and looking for opportunities in less favored sectors could help navigate the dangers and seize the opportunities that lie ahead.