NOTW #8: A Rather Unique Correction?
NOTW #8: A Rather Unique Correction?
Hi reader,
Both indices were significantly down this week, and while this might be just a normal correction, I think some things make it somewhat unique.
Without further ado, let’s get on with the article of the week.
Articles of the week
I uploaded one article this week: Diageo’s earnings digest.
The company reported a weak FY 2024 and did not give great guidance for 2025. Still, I believe the results are not as worrying when one looks below the surface.
Market Overview
Both indices were significantly down again this week. The Nasdaq dropped more than 3%, whereas the S&P 500 fell more than 2%:
There’s no denying it’s been a pretty volatile couple of weeks, especially considering the low volatility we’ve had over the past months. The Nasdaq entered correction territory this week (more than 10% off highs), whereas the S&P is still barely 6% off highs. This is quite remarkable if one thinks about the sentiment there’s out there right now:
Such negative sentiment might simply be a cause of recency bias. We’ve been so long without seeing a few consecutive red days that many believed this could never happen again. Of course, everyone knows it can happen, but not seeing it for so long made some people think that markets would continue going up forever. The stock market is great because it tends to go up over the long term, but one never knows how it’ll do over the short term. Market drops and corrections are quite normal, and they all tend to be scary because recency bias kicks in but in the opposite direction.
I’ve spoken about this topic several times, but according to Schwab, 10% drops occurred in 10 of the last 20 years, meaning that it’s almost impossible to be invested two years in the market without suffering a 10% drop. Many investors try to time these market drops, but there’s a “problem” with this strategy. The best days tend to follow the worst days, and these days are critical to enjoy good long-term returns. This eventually means that one has to be extraordinarily precise with their timing to make this a profitable strategy:
Investing is tough because what many people wish for when things are going well (a correction) ends up being their worst nightmare. Many claim that they’ll buy “XYZ stock when it drops xx%,” but the reality is that few people end up doing it. The reason is obviously related to emotions (we believe everything will keep going down further) and the fact that the landscape might not be as rosy when a stock has dropped significantly. If an investor has not done his homework in advance, then it’s most likely he’ll believe the current struggles are structural and not temporary, which is typically the case for high-quality companies even when it seems impossible to envision a good future. Even if you’ve done deep research on a company, the most likely scenario is that buying when it’s significantly down is not the most enjoyable thing; it takes some kind of “blind” trust or implicit conviction to make such a purchase, and this can only be built with deep knowledge.
Despite market corrections being normal, I’d say this one is somewhat special for two reasons. The first one is that indices have become so concentrated that the underlying weakness is much greater than the indices portray. Indices might be only 6%-10% off all-time highs, but many companies are considerably more off ATHs. Indices have performed so well because their largest contributors have not suffered too much of a correction…The worst performers of the 5 largest contributors to the Nasdaq are Nvidia and Broadcom, and they are “barely” 20% off highs:
This drop doesn’t seem worrying either, considering these companies have risen 440% and 219%, respectively, over the last 3 years. Another thing that makes this somewhat strange of a correction is how volatile the current earnings season has been thus far. There are two data points to support this. The first one is that the rise that the VIX saw on Friday is among the top 10 most significant spikes in history (granted, the VIX is not that old). The second one is that, according to Goldman Sachs, the current earnings season has been the most volatile since the Global Financial Crisis. Not a small feat!
Anyways, volatility is not bad, but the current correction and both of these “extraordinary” variables make me understand better why some people might be starting to get worried. Volatility is an opportunity for patient investors, especially when a good chunk comes from macroeconomic worries.
The US reported job numbers on Friday, and unemployment ticked up to 4.3%, triggering what many know as Sahm’s rule. Sahm’s rule has apparently been a great predictor of future recessions, but so has an inverted yield curve, and markets have rallied significantly since the yield curve became inverted. While still moderate, the rise of unemployment has triggered many people to claim that the Fed has absolutely no clue what they are doing and should’ve lowered interest rates a long time ago. I’ve heard this story before and it was barely some months ago when many believed it would be impossible for the Fed to get inflation under control. The reality is that the Fed did a pretty good job during and coming out of the pandemic (of course, we only know this in hindsight).
Could we eventually face a recession in the US? 100%. In fact, that’s the most likely scenario over a considerable amount of time. Knowing the kind of companies I hold in the portfolio, I am not worried, though. High-quality companies tend to come out stronger during recessions.
The industry map was primarily red this week, except some considered defensive industries like healthcare, which performed well:
The fear and greed index dropped considerably and is now almost in extreme fear. We went from neutral to almost extreme fear in just one week, portraying how quickly sentiment can change in the market. Note that price dislocations occur because sentiment changes much faster than fundamentals:
This is all for this week! Have a great weekend!