Tech wreck? Correction? Higher volatility? - J.P. Morgan Asset Management

Tech wreck? Correction? Higher volatility?

Contributor David Lebovitz

In sports, teams often take time between the first and second half of a contest to discuss what they need to do in the second half to improve their performance. Investing is no different, so with the first half in the books, we wanted to address some of the top questions we have received during the past few weeks, and provide some insight on what we think could happen in the second half of 2017.

Is the sell-off in tech a cause for concern?

Some investors are concerned that stock market gains this year have been primarily driven by a few large technology stocks, and that the recent weakness in this sector could lead to a broader drawdown for the market. While it is true that the 10 largest stocks have been responsible for nearly 36% of the S&P’s year-to-date return, remember that in 2015, a handful of stocks were responsible for all of the S&P 500’s return! Additionally, the top 10 names account for a much smaller share of the index than was the case during the tech bubble. In 1999, the 10 largest stocks in the S&P 500 made up nearly 30% of the index - today they only account for 19%, just below the long-term average of 20%.

More important, however, is the fact that technology sector fundamentals remain supportive. Although relative and absolute valuations have risen, they are below the levels seen both prior to the financial crisis and during the tech bubble. Also, earnings growth looks set to remain robust, with Standard & Poor’s forecasting that the technology sector will see earnings grow by nearly 30% in 2017. Finally, from a behavioral perspective, investors seem to be viewing technology – and growth stocks more broadly – in a slightly different light. Investors have historically bought growth stocks when confidence is high, but during the past few years, growth stocks have been purchased for their ability to generate earnings and revenue growth despite a more moderate economic backdrop. Furthermore, the correlation between growth stocks and interest rates, which has historically been positive, has recently moved into negative territory, indicating that investors believe buying growth stocks is actually a way of playing defense in the current environment. This combination of sound fundamentals and an attractive behavioral component suggests that while technology shares may not be immune to a pullback, a more serious decline in prices seems unlikely.

Should we be concerned about lower oil prices?

Watching oil prices decline over the past few weeks has brought back memories of 2015, when a sharp decline in energy prices, coupled with a stronger U.S. dollar, led to a two year earnings recession, a blow out in high yield spreads, and a slowdown across emerging markets. Investors are now asking whether we are setting ourselves up for a repeat of these events.

Starting with the fundamentals, this decline appears to have been driven by too much supply, rather than a softening in demand. Additionally, many energy companies with business plans that were dependent on oil remaining at $100 per barrel have defaulted, leaving the energy sector healthier and more efficient than it was just a couple of years ago. In fact, research from the Dallas Fed suggests that U.S. shale producers can cover expenses for existing wells when oil is above $30 per barrel, and only need oil prices around $50 per barrel before drilling a new well makes sense. Finally, energy company earnings have been plagued by impairment charges, as companies have written down their oil-related assets significantly. With these serious impairment charges having already been taken, along with an improvement in efficiency, it seems unlikely that the most recent pullback in oil prices will have the same impact on earnings and financial asset prices as was the case a few years ago.

This lack of a fundamental threat has also been reflected in markets. High yield spreads tend to send a fairy clear signal about the health of corporate America and investors’ willingness to take risk. With spreads outside of the energy sector still sitting close to cycle lows, it does not appear that the weakness in energy prices is generating concerns about the health of corporate balance sheets more broadly. Looking at equity market performance, energy stocks have come under pressure as the price of oil has fallen, but the correlation between oil prices and the broad S&P 500 is nowhere near as positive as it was from 2014-2016. While we will need to continue watching for signs of contagion, at the current juncture, the stress in the energy sector appears contained.

How much longer can this bull market continue?

There are a number of good reasons why the current bull market looks set to continue. First, there are fundamental supports. Yes, valuations are above average and imply lower returns going forward, but they are well below levels seen in the early 2000’s. More broadly, valuation is not a very good tool for predicting bear markets.

Second, the pace of earnings growth looks solid; earnings growth should slow during the second half of 2017 as year-over-year comparisons become more difficult, but with drags from the energy sector and U.S. dollar behind us, S&P earnings look set to continue trending higher. Also, it is important to remember that nearly 45% of S&P 500 revenues come from outside the U.S. - with global activity data looking healthier, this could provide a further boost to corporate profitability.

Third, monetary policy does not look set to tighten aggressively. Lower readings on inflation will not stop the Fed from hiking, but may slow the pace at which they normalize policy. A gradual normalization of monetary policy should not be a headwind for risk assets, but investors should keep an eye on whether the FOMC begins to adopt a more hawkish tilt. Finally, new highs are not the same as new peaks - the S&P 500 set 18 record highs in 2016, and this trend has continued so far this year.

While a continuation of this bull market will not occur without volatility, it is important to remember that volatility is normal and should be expected. During the past 37 years, the S&P 500 has fallen by over 14% on average during the course of the year, but finished in positive territory in 28 of 37 years, more than 75% of the time. Although recession risks may begin to build next year on the back of rising inflation and a more aggressive Fed, we continue to believe that there is still room for stocks to run. At the current juncture, the key is to let asset allocation work for you - have a plan, stick to that plan, and stay invested.

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