It says a lot about market psychology, and maybe even more about the generational composition of today’s investor base and the average age of journalists, when a handful of bad sessions for equities, including a 2% down day for the S&P, count as “scary.”
“Scary” was bandied about by financial media outlets towards the end of another interesting week. I don’t think it’s the best adjective. Or at least not if we’re talking strictly about equities. If you’re “scared” by a 5% dip, a technical correction (i.e., a 10% selloff) or even by a technical bear market (i.e., a 20% downtrade) stocks aren’t for you. I don’t know how else to put it.
As a general rule, you should be prepared psychologically to cope with drawdowns of 40% to 50% on the equities side of your portfolio. The chances of a drawdown that large are vanishingly small at any given time, but if you’re a long-horizon investor, you’re probably going to see, over the course of your lifetime, at least one, and probably two, serious market “events,” during which a vanilla blue-chip portfolio suffers material losses. Temporarily.
To the extent younger investors aren’t psychologically prepared for that, it’d be odd: This is a cohort which lived through March of 2020, after all, one of the most terrifying months in modern market history, and a cohort which makes financial decisions by reference to a pair of acronyms, one of which counsels throwing caution to the wind because life’s short and reincarnation’s a myth (YOLO), and the other glorifies rollercoasters (HODL).
So, maybe it’s inaccurate to attribute market fear, such as it is and to the extent it exists, to young investors. These are battle-hardened alt-coin warriors with nerves of steel, their disposition tempered in the fires of the meme stock mania. 40% drawdown once every half-century? Please. They’ve suffered, traded through and ultimately survived, dozens of 90% drawdowns and total wipeouts in the last three or four years alone.
To be sure, we have seen a few genuinely harrowing sessions this month, where “genuinely” means professional investors, hedge funds and “real” traders had cause to sweat given acute reversals and some FX fireworks, but nobody went out of business. And the average guy on the street (as distinct from The Street, proper noun) didn’t suffer existential losses on the historic short squeeze in beaten-down cyclicals (i.e., the multi-standard deviation rotation out of consensus longs and into small-caps), nor did any Jane Does lose their life savings on wrong-footed yen shorts (Mrs. Watanbe jokes notwithstanding).
Who, then, is afraid of the big, bad mini-correction? Probably nobody, to be completely honest. The financial media’s just fishing for clicks with scary-sounding headlines.
And yet, I gotta say, the sheer scope of the rally in the US mega-cap leadership and the eye-watering concentration risk inherent in the index weighing of the top five, Mag7 and top 10 names is, for lack a better word, scary at this juncture. I generally downplay that risk for one simple reason: These aren’t just good companies, and they aren’t just great companies, they’re the best companies in the history of companies, and their products and services are by now synonymous with daily life for about half the planet. That’s — ummm — one helluva MOAT.
But as noted here, the top five names now comprise nearly 30% of S&P market cap and the top 10 nearly 40%. That’s uncharted territory, and it’s not close. The figure below, from BofA’s Michael Hartnett, makes the same point.
At the height of 2021’s infamous “everything bubble,” when Tesla peaked with Bitcoin, the Mag7 was 30% of market cap. Now it’s meaningfully higher. 2021 was “before” Nvidia (not literally, of course, just before Nvidia became the poster child of a new tech epoch), but nevertheless, this is beginning to feel decidedly dicey.
Next week, Amazon, Apple, Meta and Microsoft will all report. If the market’s reaction to results from Tesla and Alphabet’s any indication, no one’s in the mood for anything less than beats, and more to the point perhaps, investors are running out of patience with the disparity between AI capex and revenue generation. Already. They’re already running out of patience.
That latter point’s concerning, I think. The AI frenzy’s a mere 14 months old, dating from Nvidia’s Q1 2023 game-changing earnings release. This is going to take some time, folks. And it’s going to be very costly on multiple fronts. It’s entirely unrealistic to expect the so-called “hyperscalers” to recoup all of those costs in real-time, which is what it feels like investors are asking them to do. That’s not how capex generally works, let alone R&D.
It’s absolutely possible that the mini-correction in big-cap tech and the Mag7 (which suffered its largest eight-session drawdown since October in recent days) is already over, which is to say next week’s mega-cap earnings could allay fears, everybody could jump back aboard this ship and sail away happily into the summer sun. It’s also possible that even if next week’s tech earnings fan fears further, and next month’s seasonality lives up to its nefarious reputation, Nvidia will ride to the rescue in late August (when it reports) just in time for Jerome Powell to confirm (at Jackson Hole) the September rate cut he’ll probably tip at next week’s FOMC meeting.
But if nothing else, recent events are a reminder that this “magnificent” cohort of companies upon which the entire market turns, can sell off. And when it does, it’s challenging for the “broader” market to stay above water, precisely because the broader market isn’t actually very “broad.”
That’s always been the problem with the so-called “catch up” bull thesis which, to oversimplify, says everything will be fine (or at least that everything could be fine) even if big-tech corrects. There’s a very real sense in which that’s not possible. This is 30% of market cap we’re talking about here, and an entire year’s worth of upside in that group can be traced almost entirely to one narrative (i.e., the AI story). If nothing else is, that’s pretty scary.
“Battle-hardened alt-coin worriors”…LOL
My wife and I married in 1967 and began investing that year. The DJIA topped in 1966 and didn’t break that top for 16 years in 1982, ironically in the midst of a deep recession, high inflation and ultra high interest rates that hit 20%. Another large stock market dead period hit toward the end of the last century, lasting more than 10 ten years. I was awash in bonds and never noticed. For more than 30 years in the midst of my investing life, bonds out-earned stocks and young investors had little to turn to but CDs. Since the great unpleasantness of 2008 stocks have done much the same as bonds did a couple decades before, go straight up. By then I had retired and bought few stocks as I wanted income not gains. Today, folks like Robinhood, Schwab and Fidelity are trying to convince younger investors, the ones with college debt, that $50 bucks makes you a stock investor. Sadly, it doesn’t. Morgan wealth has an ad showing a guy in a bar, playing with his phone, trying to figure out if taking a couple hundred in gains makes him some sort of tycoon. A big part of the financial community seems to be bent on getting the newbs to see investing as an alternative to Fanduel. That won’t make them happier down the line. Neither will day trading in meme stocks.
Dr. L, I love the Fanduel comparison. It’s spot on now that you can risk money calling the next pitch or next play while you watch a game. And to think how many of us once ridiculed the Chinese for betting on everything!
Does anyone else see parallels with ancient Rome?
One risk is the reversal of the wealth effect for the economy and the stock market. Lots of people talking about great their 401ks or retirement funds are doing, in US and in an Asian country I just visited. Financial districts will see many hanging heads if this sell-off gains steam and moves into that -20% range you referenced. And ppl in 30s and 40s will start to worry if there’s no Fed or government generated rescue to bounce stocks w/n a month or so of a sharp decline.
AI hype reminds me of the genome sequencing buzz and a failure by many investors to recognize and/or accept genetic research takes years and many $ to produce biopharmaceuticals. Biotech stock collapse is rarely distinguished from the dot.com bubble.
100% agree on the genome mania comparison.
It’s a great technology, but real-world applications are sadly taking longer to appear than most equity “investors” can tolerate. “You Can’t Hurry Love” ….
If things go to plan, I’ll ride a leveraged bond ETF through a 40% drawdown in equities and then plow it back into a leveraged S&P500 ETF just in time to launch myself into the top 1% and retire to a job that doesn’t involve moving numbers around in a spreadsheet. Yeah, that’s the ticket!
I have my dad (90) 100% in bonds, but I struggle to have any conviction about where the stock market and 30 year interest rates are headed.
Just curious- will you share what you see happening that will result in a 40% equity drawdown?
Sorry, I should clarify that I think that’s very unlikely. I’m not even sure what could drive something like that knowing that the government and Fed will pull out all the stops for anything serious (e.g. a pandemic). A real war between the US and China or massive natural disaster is the only thing I could see causing something like that at this point.
I know H has talked about concentration risk a lot which is something to keep an eye on, but these big tech companies have oligopolies at this point, so I expect them to keep making outsized profits and reaping the benefits of being long duration and growth stocks. I also think they will benefit most from AI, both from a revenue and cost perspective (although one or two may fall due to AI).
All that to say I would be absolutely shocked by a 40% drawdown, but never say never. I do think interest rates will head back down toward zero and will likely happen quickly once the economy does get dicey, but I have no idea when that might be. I would be less surprised by the economy and market holding strong than if we had some major drawdown of 25%+.
I thought you might’ve been a bit facetious- but wasn’t sure. 🙂
I sold (in my IRA) a big chunk of Nvidia recently at $121; and almost immediately regretted that. Might repurchase some if it continues lower.
In the last 15 years, all of my major gains have come from positions in individual tech stocks. I used to be willing to put everything in one stock. Now, I try to keep an individual stock position at less than 20% of my portfolio. I definitely took (and continue to take) to heart H’s ongoing advice to be prepared to lose half!
I don’t recommend this, however, unless you are somewhat unhinged and prepared to deal with the consequences.