why are former high fliers crashing?

There are two forces at work that are causing the weakness in former high-flying names in the US stock market:

1.  The lesser of the two, I think, is worry by predominantly European investors that Chinese will slow more than expected and that EU economic progress will be hurt by Russia’s expansionist tendencies.  It’s less those tendencies, in my view, than the fact that Russia supplies a lot of the natural gas the EU uses, and that the delivery pipeline goes through the Ukraine.

So EU portfolio managers are becoming defensive in a very conventional way.  This means moving money out of small caps and into large, pulling back from foreign markets to reinvest at home, and shifting away from issues whose attraction is strong future growth and toward (defensive) names that look more like bonds.

2.  More important is recent Fed action in continuing its very early steps toward normalization of domestic interest rates, despite apparent first-quarter slowdown in growth.  This affects stocks in a number of ways:

–during periods of interest rate rise after garden-variety recessions, stocks in general typically go sideways.  My guess is that this is the way events will play out this time around.  But the Great Recession was so deep–and Fed monetary accommodation so huge–that to some degree we’re currently in uncharted waters.  So Wall Street is nervous.

–rising interest rates are devastating to the valuation of stocks whose price is justified mostly by earnings far in the future.  If we calculate today’s value of $1 to be paid to us in five years using current 10-year Treasury bond rates, we find it’s worth $.90.  If we use an interest rate of 5%, which is what the Fed says it’s ultimately aiming for, then that future dollar is only worth $.78.  That’s about a 15% drop.  If the dollar is only going to be paid in ten years, then its present value shifts from $.81 to $60, a 25% fall.

For many “concept” stocks no one really knows for sure the timing of future earnings.  Even experienced Wall Street securities analysts struggle to forecast next year’s earnings, so in reality they only a general sense of the way future profits may be trending.   Still, whether we have precise figures or not, rising interest rates make future earnings much less valuable to an investor today.

–it’s a commonly held belief–and a correct one, I think–that when there’s too much money sloshing around in the economy it finds its way into highly speculative areas.  Highly leveraged transactions and “concept” stocks are two examples.  The Fed’s declared intention to syphon away some of this excess should provoke–and has–selling in the most speculative end of the stock market.  This is different from the more rational idea that future earnings are less valuable as interest rates rise.  This is more like the casino is closing, so no one can make crazy bets any more.

what now?

If you’re concerned and realize you have an asset allocation problem–meaning you have too much money in stocks that are way out on the risk spectrum–you should make your portfolio more conservative.  Maybe you shouldn’t do 100% today, but you should at least do some.

When will the selling stop?  …either when the negative emotion currently in the market dissipates (it’s hard to be very fearful for an extended period of time) and/or stocks that are being sold off begin to look very cheap.  In the case of stocks whose earnings payoff is, say, five years in the future, some are starting to look more reasonable.  the market overall cheap?    …not yet, in my view.  In normal times, we’d have to see the market testing the bottom of the channel we’re in before veteran traders would step in.  That’s 5% – 6% below where we are on the S&P 500 now.



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