The Case for a Pullback

I generally try to avoid making short-term market calls, but the strength in the major stock-market indices over the past few weeks in the face of some formidable headwinds makes me think that stocks may be ahead of themselves. Let me explain. 

The S&P 500 and Nasdaq are now up over 9% and 24%, respectively, for the year (excluding dividends). This impressive performance has been underpinned by remarkable strength in just a few mega-cap Technology and Communications Services stocks, which are best represented, in my opinion, by the NYSE FANG+ Index. The FANG+ Index contains just ten stocks, including META (Facebook), Tesla, NVIDIA, AMD, Netflix, Apple, Amazon, Snowflake, Microsoft and Alphabet (Google). I wrote about the heavy contribution from these few stocks in my Market Commentary from May 18. At that time, I postulated that the acceleration in demand for these stocks in recent weeks may have reflected, in part, a desire to hedge against the risks surrounding debt ceiling negotiations. My argument was that these companies, with their outstanding balance sheets and huge cash reserves, could be serving as a safe-haven for investors worried about market volatility and/or the US government’s deteriorating credit profile. 

But in the back half of last week, we started to see the outlines of a debt-ceiling compromise come into focus. Predictably, investors sought to front-run the consummation of a deal by buying stocks on Thursday and Friday, pushing the S&P 500 and Nasdaq up over 2% and nearly 4%, respectively, over that two-day span. Less predictable, in my opinion, was the 6% increase in the FANG+ Index over those two days. That 10-stock index is now up nearly 64% for the year compared to just shy of 10% for the S&P 500 and compared to a slight decline in the S&P 500 equal-weight index (which assigns a weighting of 0.2% to each of the 500 constituent companies). The continued performance concentration among such a small number of stocks, also known as a weak breadth, concerns me. My questions are many:

• If the FANG+ stocks indeed benefited from a “flight-to-safety” due to the debt-ceiling risks, why hasn’t that trade reversed now that an agreement seems at hand? I see two possible scenarios going forward: 1) the deal gets done, this risk is eliminated, and money that flowed into “safe” stocks reverses; or the much less likely scenario, which is 2) the deal falls apart, US debt gets downgraded and all risky assets drop. It seems to me that either way, the FANG+ names will come under pressure, at least on a relative basis.
• For years we heard that low interest rates were the best justification for owning stocks, especially “growth” stocks that won’t provide investors with meaningful cash flows (dividends) until many years into the future. Well, interest rates have now risen significantly since their lows earlier this year as the markets are finally adjusting to incoming data and the Fed’s hawkish rhetoric. Given the increase in interest rates, why aren’t these high-growth FANG+ stocks, which are the most sensitive to rising interest rates, responding to the increase in interest rates?
• Given the strong rally in “growth” stocks as the debt-ceiling negotiations intensified, why haven’t we seen a technical sell-off? Investors typically “buy the rumor and sell the news.” This time we are seeing “buy the rumor, buy the news.” Could this mean that the deal is still at risk?
• It’s not at all clear that the disinflation we’ve seen to date will continue. As noted, stocks rallied at the tail end of last week. That rally came in the face of a hot reading for the April PCE deflator on Friday morning. It appeared as though investors preferred to focus on debt-ceiling negotiations rather than the hot inflation data. In any case, it’s pretty clear that the US consumer, and particularly the labor market, is proving more resilient than many had thought. If that’s the case, why are stock investors ignoring the Fed’s repeated pronouncements that interest rates will remain high until inflation comes down to the 2% target?
• There are also plenty of signs that economic growth has slowed materially. Perhaps most ominously, commodity prices (like oil, copper, lumber and even wheat) have plummeted even as services prices are keeping inflation metrics above Fed targets. If the global economy is slowing and inflation and interest rates are expected to remain high, why are investors piling into equities (especially high-growth equities)?

I know what you’re thinking. If we’re worried about a near-term correction in stocks, shouldn’t we be selling? Well, the short answer is that long-term investors should remain invested because there is no way to predict the short-term gyrations in stock prices and missing just a few of the market’s best trading days can decimate long-term portfolio performance. For more trading-oriented “investors”, the answer is that it depends. If your stock portfolio is heavily concentrated in the FANG+ names that have accounted for most of this year’s gains, I do believe it makes sense to consider paring back some of those positions (albeit at the cost of some capital-gains taxes). And I say this with the understanding that there are other factors, like the excitement surrounding Artificial Intelligence, that could be contributing to the strength in the mega-cap stocks. 

The good news is that if your portfolio is diversified with positions in high-quality stocks and sectors that have not participated in this year’s rally, we believe in remaining invested. Without a doubt, the opportunity cost of owning stocks has increased with money market funds and CD’s yielding close to 5%. And at the index level, stock valuations are not really incorporating that higher opportunity cost with the S&P 500’s forward P/E at 18.3x compared to a long-term average of about 16.4x. But successful investors are able to separate the wheat from the chaff, drown out the noise and maintain discipline through many market environments. There are many, many high-quality stocks that are not participating in this year’s equity rally and that still trade at very reasonable valuations. Though it can be tough to watch your friends and neighbors make big gains on the hottest stock, it’s the tortoise that usually crosses the finish line faster than the hare.