US equities fell sharply on Friday, ending the week down 1.9%. Consumer cyclical stocks led the decline falling 4% driven by falls in sector heavyweights Tesla TSLA and Amazon AMZN of more than 5%. Commentators seeking to explain this fall have gravitated toward weak housing data and consumer sentiment. However, the lack of substantial movement in Treasury yields or interest-rate expectations (as indicated by CME FedWatch) suggests little fundamental change. Consequently, last week’s moves can best be explained as a change in market sentiment prompting a rotation from expensive stocks into cheap ones.
This view is supported by the performance of markets outside the United States, with the Developed Markets ex-US (down 0.2%) and Emerging Markets (up 2%) indexes faring better last week. Over the year to date, previously unloved markets such as the UK (up 5.7%), China (up 16.1%), and Germany (up 11.9%) have been especially strong in local currency terms despite rising geopolitical tension. This reminds us to avoid tying market returns to political events and perspectives.
The picture is more nuanced when comparing small- and large-cap stocks. At the headline level, US Small Companies have remained out of favor (falling 3.2% last week). However, digging deeper, we see further signs of a rotation, as Small Value (down 2.6%) declined less than Small Growth (down 4.4%), narrowing the gap between them. You can see how these relationships are evolving on the Morningstar Markets page.
Should this rotation continue, headline returns could become negative, at least in the short term. How should investors respond? Here are three tips:
- Remain humble when making forecasts: While valuations provide a fundamental reason for this current rotation, markets are inherently unpredictable. Keep an open mind about all possible outcomes.
- Don’t sell too soon: There’s often a “self-reinforcing” aspect to price movements, and fundamentals can follow them. Consequently, fair value estimates on expensive stocks can decline over time, while estimates of cheaper stocks may rise. Exiting positions prematurely can mean missing out on structural recoveries.
- Stay focused on the long term: Avoid attempting to trade short-term volatility, as this exposes you to behavioral biases that can ruin returns. Jeff Ptak recently wrote an insightful piece on leveraged ETFs, underscoring how tricky timing can be.
The master of this long-term approach is Warren Buffett, CEO of Berkshire Hathaway BRK.B, which released its earnings results over the weekend. Reading Buffett’s annual letter to stockholders is one of the highlights of my investing year. Gregg Warren has been covering Berkshire for a long time, and he was part of the panel that would grill Buffett and his longtime partner Charlie Munger at their legendary annual meetings. You can read Warren’s perspective on Berkshire’s latest results.
With earnings season winding down, this week, the spotlight will be on Nvidia NVDA. Brian Colello has outlined the expectations for the firm’s results. Elsewhere, economists will be focused on Friday’s latest inflation reading, particularly the core Personal Consumption Expenditures Index measure. Consensus forecasts put annual growth at 2.6%, slightly lower than last month’s 2.8%. Any material deviation from that figure could introduce fresh volatility to close the week.
The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar's editorial policies.
