by Franklin J. Parker, CFA
The Summary
- Investor moods shifted dramatically last week with an “everything selloff” hitting markets. US stocks sold off 2% of their value, long-term US Treasuries (usually a safe-haven) sold off along with gold, bitcoin, and international markets. It is difficult to pinpoint exactly what pushed investors over the edge, but the deteriorating economic news out of China appeared to be the main culprit. A slowdown in the world’s second-largest economy (and largest exporting economy) spells trouble for the global growth outlook, and may be an early indicator that the import-based economies (US, EU, Japan, etc) are themselves slowing down as well.
- This is a light data week, although the Federal Reserve begins its annual Jackson Hole retreat on Thursday. Investors will be listening closely for clues from the Fed on both rate policy going forward, as well as their own economic outlook. Conflicting messages have come from FOMC members lately, some advocating for another hike before year-end and others calling for a “wait and see” approach. Both are relevant to markets and consumers who are now grappling with the highest borrowing costs in a generation.
- While earnings season is almost entirely over, this Wednesday (after market hours) we see earnings from NVDA — a stock at the center of the AI-on-Wall-Street hype. After gaining 188% this year, this earnings call will be a test of its very lofty valuation (a topic I have written about before). A quick look a analyst estimates shows that investors expect a 300%+ growth in earnings this quarter… which will be tough to deliver. Given that much of the US stock rally has been driven by tech and AI hype, it seems likely to me that the market as a whole is somewhat fragile with respect to poor news on that front. Wednesday will be telling.
The Details
Diversification: I don’t think that word means what you think it means.
Diversification is one of those fundamental words that gets thrown around a lot in finance. We all know what it means conceptually: “don’t put all your eggs in one basket.” But, what does that mean in practice? That is, unfortunately, where many investors get squirmy.
For some, diversification means owning as many individual securities as possible: own everything you possibly can. The rationale, of course, is that if one security fails, the rest are there to cushion the fall and make up the difference. For others, diversification means owning different asset classes, like stocks, bonds, and commodities. The idea here is that each of these asset classes tend to move differently but all drift upward over time. When stocks sell off, for example, bonds can be expected to gain value.
My view of diversification is different in one very important and nuanced way. While the above ideas are true (and I subscribe to them), there is one added component that most investors miss.
Diversification means diversifying the factors driving your investments. Owning stocks and commodities is only diversified if the factors pushing the prices of stocks is different than the factors pushing the prices of commodities. If stocks and commodities are both driven by the same factors, then we aren’t actually diversified. World War II is an example of this: during the war, everything in the global economy was driven by one factor alone: war. Diversification was difficult, if not impossible, in that scenario.
Today we see something similar in central banks. Central banks, globally, have been the primary driver for the prices in just about every market. Housing, commodities, stocks, bonds, even the price of cars, can trace its cause back, in no small part, to central banks. This has made diversification difficult, and given us moments like last week, where everything sells off together.
As central banks normalize monetary policy, it will be important for investors to be cautious and not rely too firmly on diversification to save their portfolios. Given that everything is being driven by the same cause, we may need to rely on techniques other than diversification to keep portfolios on track to hit our goals.
Chart of the Week
Recovering the jobs lost during COVID was not limited to any particular industry (though hospitality, hardest hit in COVID, saw the largest gains). In the last year, by contrast, we have seen largest job growth in health & education. The pace of job creation has slowed, though that is to be expected after the COVID recovery.
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