FINANCIAL MARKET UPDATE 9.15.2020

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

CORRECTION IN GROWTH STOCKS

After a blistering summer rally, the high-flying growth stocks of the Nasdaq 100 hit a wall in early September. In just three trading days, the index saw its value drop by more than 10%, exceeding a threshold for what defines a “market correction.” Corrections are a healthy part of the normal ebb and flow of the stock market and help clear away some of the excesses that build up when the market runs too far too fast.

High-growth companies, including many firms in the technology sector, have led the rally following the steep sell-off earlier this year. Intuitively this makes sense. While the response to the coronavirus outbreak continues to wreak havoc on various industries, it has been a tailwind for others. This includes the technology that has enabled the shift to remote work. I don’t believe I had ever heard of Zoom prior to 2020, but even as I wrote this, I had to pause and hop on one of the many Zoom calls I have scheduled this week.

The strong stock performance of high-growth companies may have been justified early in the rally, given their relatively strong operating results. More recently, however, the gains seem to have gone too far. As more investors have piled in to chase high returns, prices have moved beyond reasonable levels. This has been exacerbated by the expanded use of options by both retail and institutional investors to make leveraged bets on continued gains. 

The chart below illustrates a composite of valuation ratios for large-cap growth companies relative to the U.S. stock market as a whole. The key takeaway is that while large-growth companies have enjoyed relatively good operating results, it is not enough to justify the sky-high prices investors must now pay to own them. This is evident by the fact that valuation ratios are rising, which is a consequence of the price gains outpacing the fundamentals. Simply put, prices are rising because investors are willing to pay more of a premium for growth than usual. When valuations become this stretched, it typically does not take much for prices to correct back to normal levels, which is what we have just witnessed.

Source: Morningstar Direct, data through 8/31/2020. The relative measure compares an equally weighted composite of P/E, P/B, P/S, and P/CF for the S&P 500 Growth index relative to the Russell 3000.

The opposite is currently true for value companies. These firms typically trade at a discount relative to the stock market as a whole, but that discount is currently significantly larger than normal. The discount effectively prices in the fact that some of these businesses were likely adversely affected by the pandemic. Even small improvements to the outlook for these companies could justify a rise in prices to move valuation ratios to more normal levels.

Source: Morningstar Direct, data through 8/31/2020. The relative measure compares an equally weighted composite of P/E, P/B, P/S, and P/CF for the S&P 500 Value index relative to the Russell 3000.

The valuation gap between growth and value stocks remains large and would require more than a 10% drop to normalize. This is particularly true given value stocks sold off in early September as well, just not as severely as growth. It’s possible the correction will signify a change in market leadership, but market imbalances can persist for extended periods. Value investors should be prepared for continued growth out-performance.

WEEK IN REVIEW

  • On Wednesday, the Federal Reserve will conclude its meeting of the Federal Open Market Committee (FOMC). The Fed is not expected to move rates from near zero. They will provide an updated “Dot Plot”, which illustrates the economic projections of the committee, as well as the expected future path of the Federal Funds rate. The market pays significant attention to the Dot Plot, particularly when investors anticipate a potential change in the policy rate (which is not currently the case). Finally, investors will look for details on how the Fed plans to implement its new “average inflation” policy framework, as well as any updates to the current bond buying program.   
  • Data released last Friday showed that inflation accelerated by a small amount in August, but remains below the Federal Reserve’s 2% target. The headline figure increased from 1.0% to 1.3% YoY, while the core CPI (which strips out the volatile food and energy components) increased from 1.6% to 1.7%. Prices for used automobiles were the largest contributor to the increase. As long as inflation remains low, the Federal Reserve has little reason to do anything to tighten monetary conditions.
  • Important events in the week ahead include the FOMC’s policy announcement Wednesday at 1 CT (followed by a post-meeting press conference on Yahoo Finance shortly after). Additionally, the August retail sales figure will be published Wednesday morning and updated jobless claims data on Thursday.

HOT READS

Markets

  • ‘Real’ Bond Yields Help Explain Surprising Market Moves (WSJ)
  • The Wildly Popular Trades Behind The Market’s Swoon and Surge (WSJ)

Investing

  • Are You an Investor or a Gambler? The Stock Market Knows (Zweig)
  • Republicans or Democrats: Who is Better for the Economy? (CFAi)

Other

  • You Have a Million Tabs Open. Here’s How to Manage Them (Wired)

ECONOMIC CALENDAR

Source: MarketWatch

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is a Senior Portfolio Manager & Head of Research at Lutz Financial with over nine years of investment experience. He is responsible for assisting clients in the construction, selection, and risk assessment of their investment portfolios. In addition, Josh will provide on-going research and trade support.

AREAS OF FOCUS
  • Asset Allocation & Portfolio Management
  • Investment & Market Research
  • Trading
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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