What is certain is that it is the result of a significant bull-market reset that is undoing isolated excesses, pricing in a more grounded economic reality, and helpfully lowering investor expectations.
The Dow Jones’s 5.2 percent drop from its September 2 record high to the end of the month Thursday – narrowed by Friday’s 1.2 percent bounce – was the headline index succumbing to an undertow that had been dragging on the market since June, when cyclical and “reopening” stocks peaked.
Throughout the Dow Jones’s upward grind in July and August, the common complaint was that market breadth was lacking, with the rally consisting of a select few big growth stocks trudging higher.
Now that the index has “caught up” to the average stock, the S&P 500′s year-to-date gain is perfectly aligned with that of the median stock as measured by the equal-weighted Russell 1000 – up an impressive 16 percent.
Both of these indexes are 3.5 percent to 4 percent below their peaks, but most stocks have taken far more damage. A third of the Dow Jones was at least 15% off its high on Friday, and half of all Nasdaq issues were down 20% or more.
Since the spring of 2020, the market has been buoyed by steadily rising corporate-earnings forecasts, with the S&P frequently outperforming the consensus profit target.
Deutsche Bank & Co.
While year-ahead estimates have flattened out slightly, the recent Dow Jones downturn may have begun to rebuild a valuation cushion, making the price/earnings relationship appear a bit less aggressive, now at 20 times expected profits over the next 12 months. It’s not cheap, but it’s less demanding than it has been for the past year and a half. Major winning streaks are reset.
After a couple of extended winning streaks, the market has also reset the clock to zero. September brought the Dow Jones’s streak of up months to seven, as well as one of the index’s dozen longest stretches without at least a 5% pullback.
The previous five seven-month winning streaks ended not at a major market peak, but rather during ongoing bull markets, such as in mid-2013 and late 2009.
And, after the initial 5% drop, which ended one of the market’s longest streaks without one, the market struggled for a little longer but never experienced anything more than a fairly normal correction. According to Ned Davis Research, all of the pullbacks eventually reached at least an 8% decline, with the next Dow Jones new high occurring between two and twelve months later.
When looking back at periods similar to the current setup, it’s a similar story in terms of a down September with the S&P still up at least 10% for the year. According to Bespoke Investment Group, the pattern was a higher-than-average chance of further downside into October, but on average rebounds to post a positive fourth quarter overall.
Investors’ moods and risk exposure have also dipped as a result of less optimism and aggression. In the same week that the American Association of Individual Investors poll showed bearish respondents climbed above 40% for the first time in a year, equity exposure among professional advisors in the National Association of Active Investment Managers poll fell toward 50%, a multi-month low.
The National Association of Active Investment Managers (NAAM) is a trade organization that represents active investment
So, if the main knocks on the market a month ago were that the top-heavy Dow Jones was diverging from the majority of stocks, that the upside path had been too steady and easy to avoid downside mean-reversion soon, and that investors were complacent and overconfident, the past few weeks appear to have addressed all of them.
Buyers of dips are missing.
This is not to say that the market’s adjustment has been purely mechanical and benign, or that it is necessarily complete.
The tape’s character has changed in such a way that the bulls now bear the burden of proof in the short term.
The Dow Jones has spent the past two weeks below its 50-day moving average after going ten months without falling below it for more than a day. For the time being, the urgency of dip buyers appears to have subsided. Late-day weakness has recently been the norm, in contrast to the majority of this year. ETF inflows have not emerged following large one-day drops in the indexes, as they had in previous months.
And, as JP Morgan shows here, retail options trading volumes, which have been a major source of buying energy since the March 2020 market bottom, have dwindled as a proportion of total option turnover.
There are numerous reasons why investor confidence has dwindled. Aside from the less-than-pleasant technical action, third-quarter economic growth is lower and inflation is higher than was widely anticipated a few months ago.
While the most economically sensitive parts of the market accounted for the June-August slowdown with consistent underperformance, third-quarter earnings forecasts are being trimmed, and supply-chain frictions may have reached their saturation point as a front-and-center worry point.
The policy front appears to be less friendly, with a clogged path to infrastructure and social-spending bills in Congress and the Federal Reserve looking to accelerate the end of its bond-buying program.
Factors that help
It’s a noisy environment, to be sure, but a few supportive factors for stocks remain: Rising Treasury yields and well-behaved credit markets suggest that economic-recovery forces are still in control. After a couple of months of underperformance, economic data has begun to outperform economist forecasts once more.
Small-cap, bank, energy, and auto stocks have been sideways or higher even as the major indexes have rolled over, implying that a messy, fitful rotation is taking place rather than outright macro weakness being priced.
For what it’s worth, a market high on Sept. 2 in an otherwise strong year would be unusual, unless the market was dealing with both an at-risk economic expansion and a Fed on a determined tightening path. This was the general setup in 2015 and 2018.
The superstitious may wonder if such a perilous concoction occurs every three years.
For the time being, those conditions have not been fully met, and the market has reset itself by consolidating and cooling off, with investors wary but also aware that year-end rallies are frequently forged in the heat of September and October mini-meltdowns.
“People invest in order to make a profit. They do not invest in order to outperform the Dow Jones. They don’t invest to win a Lipper Award,” he explained.
This year, that goal is easily met. The Natixis Vaughan Nelson Select Fund’s y-share class, which Weber co-manages with Vaughan Nelson CEO Chris Wallis, was up more than 23 percent year to date through September, easily outperforming the three major indexes. During the same time period, the Dow Jones returned just under 15%.
Morningstar has given the fund a four-star rating, and it has outperformed the Dow Jones in terms of average return over the last five years, as well as outperformed Morningstar’s large cap blend category. It is also available as an ETF under the ticker symbol VNSE.
The fund has heavy weights in some of the major technology stocks, but it has a high active share due to its small number of holdings and large positions in other names such as railroad company Union Pacific and medical device maker Masimo.
“We consider the benchmark to be a competitor. “It is not a menu or an investment guide,” Weber explained. “There is no rule that says you can’t own something because it isn’t in the benchmark or anything. It is simply another way for clients to meet their retirement goals at a lower cost.”
With only 30 holdings at the end of August, the Vaughan Nelson Select fund is unusually concentrated for a mutual fund. Weber, who has worked as a Colorado river guide and an investment banker in the past, says he doesn’t worry about having exposure in every single sector of the market.
Instead, the fund relies on the firm’s internal research team to diversify the portfolio by examining its sensitivity to various factors such as interest rates.
“We don’t want any unintended or missing factor exposures. By extension, we can look at the investable space and determine what we really need to add to the portfolio,” Weber explained.
Selection of stocks
The Vaughan Nelson Select is weighted toward value stocks, and Weber favors companies that are “generating capital, not consuming capital.”
He attributes stock-picking success to collaboration with other people in the firm and the fund’s four-person team of “equals” who challenge each other’s ideas.
“Frankly, if there isn’t dissent at every level, we aren’t doing our job,” he said.
This year’s best performer in Weber’s portfolio is a company that has invested its excess capital. Monolithic Power, a semiconductor company that increased its production capacity and product types during the recent chip shortage, has increased 30% year to date.
“They generate so much capital that they can pay a small dividend, but more importantly, they reinvest to accelerate their own growth, which is return-enhancing in and of itself. And that, in essence, is the essence of capital formation,” Weber explained.
Monolithic is not Weber’s only big semiconductor bet; Nvidia accounts for more than 5% of the fund.
When Should You Sell?
Moderna, a vaccine maker, has also been a big winner for the fund this year, though Weber has reduced his position in the stock over the summer as the stock has risen. When discussing his selling philosophy, Weber stated that it is sometimes wise to “harvest some of the good to fertilize the great.”
Rather than obsessing over every move of the price chart, he advises investors to remember why they like a stock and check to see if that idea is still intact.
“I’m less concerned if we’re wrong because the price of a security is low because it’s out of favor. “I’m more concerned if the security price has dropped because something has changed or it isn’t operating in the way we expected,” Weber said.
Keeping yourself honest about why you own a stock and allowing others to challenge you on it is an important part of investing, according to Weber.
“If you don’t know why you own it, and you haven’t put it in writing and held yourself publicly accountable for why you own it and what you think will happen — that way you can’t change your mind as the market moves — you will never know when to sell it,” he said.
Cathie Wood’s portfolio
Rising interest rates and inflation fears have weighed on Wood’s disruptive technology names in the last three months. Wood’s flagship fund, ARK Innovation, fell more than 15% in the third quarter of 2021, bringing the ETF’s year-to-date losses to around 11%. ARK Innovation is down about 31% from its 52-week high.
Wood’s strategies will suffer as interest rates rise and rising prices become a major concern for investors.
Berkeley Lights and Skillz, both ARK Innovation holdings, lost more than 50% in the third quarter.
Take a look at the companies that suffered the most losses in the third quarter of ARK Innovation.
Despite the fact that some smaller stocks suffered significant losses in the third quarter, two of the largest stocks, Tesla and Sea, gained.
Tesla is the largest market cap-weighted company in Wood’s flagship fund, and it finished the quarter up 14%. This could be why Wood has been reducing her massive stake in the electric vehicle manufacturer.
‘I’m looking for money.’
Wood sold $209 million in Tesla stock in her flagship fund on Tuesday. Tesla remains Ark Innovation’s largest holding, accounting for approximately 10.1 percent of the ETF.
Here are the largest companies in ARK Innovation by market capitalization, as well as how they performed in the third quarter.
Some of the largest ARK holdings that have dragged down the fund’s performance in the last three months include Shopify, Square, Zoom Video, and Twilio. These companies’ stocks experienced massive pandemic-induced run-ups in 2020.
Wood, on the other hand, claims that the tides are turning for her most-conviction names.
“We believe we are on the other side of the cycle,” Wood said earlier this month during an
It will be significant if Wood is correct about deflation and a return to growth. In the midst of a pandemic, Wood’s ARK Innovation rose nearly 150 percent. Wood’s most confident stocks are those that were aided in their adoption by the pandemic, such as Zoom Video, Teladoc, and Roku.
Wood also touts her firm’s five-year time horizon for her stocks, explaining that she isn’t concerned with short-term performance. Wall Street, on the other hand, has high hopes for some of her fund’s holdings in the coming year.
Analysts scoured the market for the ARK Innovation stocks that Wall Street believes are on the verge of a comeback.
Berkeley Lights has more than 260 percent upside to its 12-month price target after falling more than 50 percent in the third quarter.
Compugen, Skillz, Zillow Group, and Fate Therapeutics are also expected to see significant gains in the coming year.
This year, Wood’s other four ETFs have also underperformed. ARK Next Generation Internet lost nearly 10% in the third quarter and is expected to lose more than 4% in 2021. ARK Genomic Revolution fell by nearly 20% in the three months ending on Thursday and has dropped by roughly the same amount this year. The ARK Fintech Innovation ETF fell nearly 9% in the third quarter, but is still down less than 1% for the year.
The only fund in the black this year is Wood’s ARK Autonomous Technology and Robotics ETF. It is expected to rise by about 2% in 2021, trailing the tech-focused Nasdaq Composite.