What I Care About This Week | 2023 Aug 21

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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.

This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be taken as advice or a recommendation for any specific investment product, strategy, plan feature or other purpose in any jurisdiction, nor is it a commitment from Directional Advisors to participate in any of the transactions mentioned herein. Any examples used are generic, hypothetical and for illustration purposes only. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own financial professionals, if any investment mentioned herein is believed to be appropriate to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of production, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yields are not reliable indicators of current and future results.

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