A Correction Or a Change in Trend?
Last week was quite negative for European equities, with the Stoxx Europe 600 losing 3.6%. The flagship US equity index, the S&P 500, shed only 0.6% thanks to a powerful rally on Friday but it still posted a fourth consecutive week of decline. The dollar continued to strengthen.
After rebounding on Monday and Tuesday, technology stocks fell again, dragging down the S&P 500 and Nasdaq 100 in their wake. These indices lost 0.6% and 1.4% respectively over the week. However, the Russell 2000 US Small Caps Index gained 2.2% and the Stoxx Europe 600 edged up 0.2%. So there has been some rotation, but will it continue?
The markets were expecting too much from the Fed
On Wednesday, the message from Fed Chairman Jerome Powell was not terribly well received. On the one hand he made it clear that rates were likely to remain close to zero until 2023, a comment which should have been equity-friendly, but on the other hand he said that the economic recovery was still too weak and needed additional fiscal stimuli. As talks between Democrats and Republicans seem to have stalled, market participants reacted negatively.
Jerome Powell will testify before Congress between Tuesday and Thursday on the subject of combatting the effects of the pandemic.
Last Friday was a particularly turbulent day as it was the quarterly maturity of options and futures on indices and individual stocks (the ‘quadruple witching day'). About $14 billion-worth of equities were traded, almost 40% more than the average over the past 3 months. The S&P 500 index shed almost 2% before recouping half of its losses when the markets closed. These maturity dates were long expected given the huge outstanding options on star stocks of the Covid-19 crisis.
From a technical analysis perspective, the Nasdaq 100 and the S&P 500 closed below their 50-day moving averages, suggesting further declines. The smaller company index, the Russell 2000, also declined, but less sharply and remained above its 50-day average. The same story for the S&P 500 Value index. The fall was mainly due to the very large stocks in the technology, e-commerce and communication services sectors that had appreciated the most in recent months.
A trend takes longer than two days but this phenomenon is worth following. If confirmed, it will be quite encouraging for the ongoing bullish trend in equities. Asian markets remain relatively calm, which is also a good sign.
How much can the FAANGs tumble?
FAANG stocks (Facebook, Apple, Amazon, Netflix, Google) had unfortunately reached such high valuations that their 17% plunge from their peak in early September still leaves them with valuations hard to justify.
This even applies to Apple, the strongest of the FAANGs. A stock may have a high P/E (Price to Earnings) ratio if high-growth future earnings are expected. But Apple's gigantic size is making it difficult (or even impossible) to sustain the profit growth it has enjoyed in the past. In other words, its Price Earnings Growth (PEG) ratio now looks too high.
It would therefore make sense for the correction of the FAANGs and a few other stocks that have posted incredible rises to continue. The fact that they are the leader in their respective markets, however, gives them an advantage that could perhaps limit the damage. But it is tricky to determine at what levels. If the correction stops at their 200-day moving average level, then technically-speaking, the upward trend will continue.
Not the end of growth stocks
Low interest rates favour growth stocks because the current value of future profits is high due to the use of very low discount rates. Moreover, we are in the midst of a technological revolution, which is unlocking undetected potential.
In conclusion, it is better to turn to less gigantic and less well-known growth stocks. There are plenty of opportunities in promising sectors like the energy transition, biotechnology, IT security, etc. Asian technology stocks are cheaper than their US counterparts.
If all technology stocks are dragged down, there will be attractive opportunities.
A ‘Barbell’ approach
A barbell strategy favours two extremes (weights at each end of the dumbbells), for example combining very short and very long bonds. Our recommendation is to combine growth stocks with more traditional cyclical stocks that have been out of favour despite their quality.
The case for the latter is gaining strength, particularly with the acceleration of growth in China. During Friday's trading session, copper prices reached €6,850 dollars per tonne, the highest level in two years due to strong demand from China, the world's largest consumer of copper. Last week crude oil prices rose somewhat as demand was not as low as feared.
This is why the sector rotation seen in recent days is so fascinating to follow. .