That sudden market drop was scary for investors but long overdue

EVEN the biggest bulls probably knew, deep down, that a winning streak unseen since 2007 couldn’t last forever.

The tech-led stock rally that has turbocharged markets for the past year and a half on the promise of artificial intelligence (AI) sputtered on Wednesday (Jul 24). The Nasdaq 100 suffered its worst day since October 2022. The S&P 500, meanwhile, was dragged down by the big technology companies, plunging 2.3 per cent to end a streak of 17 months without a drop of 2 per cent or more. That was the best stretch since the start of the financial crisis.

Stocks rose on Friday after key economic data bolstered speculation that the Federal Reserve will be ready for a rate cut in September. But the turbulence has crystallised anxiety that the latest bull run, fuelled by Nvidia and a handful of other stocks, could be running out of steam. Earnings last week showed AI investments eating into profits. And as the contentious presidential election twists and turns through a historic news cycle, investors are bracing for more volatility. 

To make sense of the week’s shifts, Bloomberg News spoke with financial advisers for their perspectives. They warned about overcorrecting, but also highlighted opportunities for people who position themselves appropriately. 

Keep perspective

Last week saw big tech drag the Nasdaq 100 closer to correction territory. But the reality is that taking a longer-term view makes the drop last Wednesday look pretty insignificant. While stocks such as Nvidia and Broadcom saw declines, they are still up about 128 per cent and 36 per cent, respectively, this year. Additionally, the S&P 500 is up about 14 per cent for the year, and while that’s mostly driven by a handful of tech companies, the gains have been broadening out on bets that a Fed easing cycle will keep fuelling corporate America. 

Investors have to remember that market drops are “completely normal” and that they “shouldn’t let short-term volatility dictate your long-term investment strategy”, according to Dave Alison, of Alison Wealth Management.

Instead, Alison said the market action highlights the importance of diversification.

“These volatile times in the market could be a good time to do a strategic rebalance of a portfolio, taking gains from investments that have had good growth and reallocating it to underweight positions,” he said.

Great rotation

One important point advisers made was that while last week’s losses were steep, they weren’t broad. In fact, they could be indicative of a potential “great rotation” away from tech and into assets that should perform better in a lower-rate environment. The AI frenzy may have sucked up most of the air in the stock universe lately, but a wider slice of stocks in the S&P 500 and beyond is actually starting to do better. 

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Small-cap stocks in particular are on a roll. Jason Pride, chief of investment strategy and research at Glenmede, expects that to continue. One reason: Small-caps are more sensitive to interest rates. Rising rates made the debt of these companies more expensive, and a Fed that moves into a cutting cycle “should benefit small-cap companies whose floating-rate debt will reprice at lower levels, and will be a tailwind to earnings”, he said.

Glenmede’s calculations show small-caps near a 55th to 65th percentile valuation, meaning that about 35-45 per cent of the time, they’ve been valued more highly than they are now. For large-caps, the calculation puts them near an 80th to 85th percentile valuation.

For those investing with exchange-traded funds, Pride would favour ETFs tracking the S&P Small-Cap 600 Index, which has a profitability requirement for inclusion in the index, versus an ETF tracking the Russell 2000, which doesn’t have a similar bar.

Resist cash temptation

Money managers reiterated that retreating into cash is a classic mistake amid market turmoil. That’s because once people move into cash, they have a way of staying there, missing rebounds.

Research by Fidelity Investments has looked at the cost of missing even just a few days of a recovering stock market in the US. If a hypothetical investor started out with US$10,000 and either remained in a portfolio tracking the S&P 500 from Jan 1, 1980 to Jun 30, 2022, or missed the best five, 10, 30 or 50 days during that period, the difference in returns was huge.

The investor who remained invested through thick and thin had, with dividends reinvested, a hypothetical US$1.1 million. Meanwhile, investors who sat out the best five, 10, 30 or 50 days had returns that were 38 per cent, 55 per cent, 84 per cent and 93 per cent lower, respectively.

Marguerita Cheng, a financial adviser and CEO of Blue Ocean Global Wealth, said it’s a good reminder she gives to clients of the oft-used cliche that “time in the market is more important than trying to time the market”.

Risk tolerance assessment

Getting an accurate read on your risk tolerance is harder than it sounds. Investors tend to perceive markets as less risky when they’re going up, and riskier when they’re going down. Advisers say its worth taking a hard look at how the recent turmoil made you feel, or what it led you to do with your portfolio. One of the most valuable ways to judge your true risk tolerance is to look back at how you handled previous market drops – did you go into cash and ultimately regret it, or sit tight and enjoy the long-term gains?

A basic move to help manage risk is to rebalance a portfolio regularly so that you stick to your long-term asset allocation. It’s easy to do today on many investment platforms, and robo-advisers and other financial advisers may do it for your account automatically.

Target-date funds you own in workplace retirement savings plans may also be rebalancing for you, albeit in a more long-term way. These funds automatically divvy money up between different asset classes to provide a well-diversified portfolio, and then adjust those allocations over time to be somewhat more conservative as you near retirement age.

Many target-date funds invest heavily in stocks, since money with a long time horizon can stay invested through the market’s many cycles (and beat inflation handily). While you don’t escape volatility with the funds, the hit should be less than that of a fund tracking the S&P 500. BLOOMBERG