The equity market sell-off that began last Thursday accelerated this week, with the Dow Jones Industrial Average shedding over 800 points and the S&P 500 dropping 3.3% on Wednesday, October 10. The S&P 500 is now down 4.9% from its recent high of September 20, bringing the index back to where it was in mid-July. To put this decline into context, the S&P 500 has dropped 5% or more on 14 occasions during this bull market. The current correction has plenty of precedent, albeit not recently. As the nearby table illustrates, there were two or three corrections per year in the early part of this market cycle, but then only one in 2014 and 2015, and none in 2016 and 2017. This week’s volatility is not unusual in the broader scope of the cycle.
It is human nature to want our effects to have causes, and the financial press is working overtime to identify the reasons for the current sell-off. There is plenty to choose from: tariffs and trade disputes, rising interest rates, looming midterm elections, inflationary fears and so forth. And yet none of these developments are new news: Investors have known all of this for weeks or even months. We instead find a reason in internal market dynamics. As we and others have documented, the equity market rally for the past few quarters has been led by a small handful of names, mostly (but not entirely) in the technology sector. Narrow markets are fragile markets. Narrow leadership creates a market that can easily overreact to an external catalyst so that the real reason for a correction is not the stimulus itself, but the exaggerated response to it.
Amazon, Apple, Microsoft, Netflix, Mastercard, Alphabet and Visa accounted for over half of the market rally through the end of September. Not surprisingly, these stocks have borne the brunt of the recent downturn. Although performance year to date remains impressive – even after the past few days – the stocks that led the way up have led the way down
One difference in financial markets this cycle is the greater prevalence of passive, or index, investing. Estimates of how much of the market is held by passive vehicles varies, but most analyses calculate that the percentage has risen from about 20% a decade ago to closer to 40% today. Perhaps not surprisingly, the largest holders of these market leaders are often Vanguard and BlackRock, the two largest managers of passive index funds and exchange-traded fund (ETFs). Larger passive ownership does not necessarily lead to greater volatility, but the same price momentum that worked on the upside, and led to several years without a correction, works on the downside as well.
This reinforces one benefit of active investing, namely the ability to avoid the tyranny of capitalization-weighted indices and sidestep the momentum that creates volatility on the upside as well as the downside. Passive returns have trounced active returns over the past few quarters and years precisely because of the lack of volatility and the efficacy of momentum. This seems to be changing.
Market fundamentals remain intact, and one silver lining of this correction is that valuations are coming back to historically normal levels as earnings continue to advance. S&P 500 earnings grew 20% year over year in the first and second quarters of 2018, and consensus expectations call for similar growth in the third quarter. The market is currently (October 10) trading at 18.7x trailing operating earnings and at 15.8x consensus expectations for 2019. This is right in line with the historical average over the past 75 years.
Market disruption reminds us of a fundamental truth of investing. Investors must make a distinction between those developments that threaten to impair sentiment, and therefore price, and those that threaten to impair fundamentals, and therefore value. With healthy economic activity continuing to translate into corporate earnings growth, we conclude that the current sell-off is a correction in line with what we have seen at various other points in this market cycle.
The views expressed are as of October 11, 2018, and are a general guide to the views of Brown Brothers Harriman (“BBH”). The opinions expressed are a reflection of BBH’s best judgment at the time, and any obligation to update or alter our views as a result of new information, future events or otherwise is disclaimed. Nothing contained herein is intended as a recommendation to buy or sell any security, or to invest in any particular country, sector or asset class. Past performance does not guarantee future results.
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