How to think about this correction
In presidential campaign speeches in 1959 and 1960, John F. Kennedy noted, “In the Chinese language, the word “crisis” is composed of two characters, one representing danger and the other, opportunity.” It’s not quite correct but that didn’t stop the handy anecdote becoming a popular trope adopted by business consultants and in motivational speeches and calls to action.
The Mandarin word for crisis is indeed made up of two characters. The first does indeed mean ‘dangerous’ but the second means ‘change point’. The latter character is indeed a component of the Chinese word for opportunity, which is probably how the confusion came about.
Nevertheless, some markets have indeed arrived at a ‘dangerous change point’, and for many, it might seem like a crisis. Of course, at this juncture, it’s worth remembering market selloffs always make the front page and the boring market rallies, especially those that build over a couple of years, rarely do.
Those headlines point out the market selloff began with Friday, 2 August’s jobs data, which shifted expectations from a soft landing to a hard landing. This coincided with a Bank of Japan rate hike to support the Japanese Yen, and news Berkshire Hathaway halved its Apple (NASDAQ:AAPL) holdings to increase cash reserves. That all sounds reasonable, except…
…the sell-off did not begin with the jobs data. From the Nasdaq’s high on 10 July, the tech-laden index had fallen nearly eight per cent before Friday, 2 August’s market open. One of the big contributors to the changing equity market fortunes has been a shift in the narrative towards artificial intelligence (AI).
On July 7, just a few days before the recent peak, we alerted investors here to an important question; how will Nvidia’s (NASDAQ:NVDA) customers recover the US$40,000 per chip they are spending on tens of thousands of chips and monetise their AI investment? It remains far from obvious how the AI ‘bells and whistles’ added to Microsoft’s (NASDAQ:MSFT) Office software suite, Meta’s (NASDAQ:META) Facebook and Instagram social media platforms and Googles (NASDAQ:GOOG) search engine will inspire users to pay more and therefore help grow revenues for the megacap tech companies.
We concluded “The wide divergence between the booming share prices of Nvidia’s major customers and pretty much every other stock will need to be supported by more than hype. In the absence of a price-to-earnings (P/E) re-rating across their market, substantial growth in revenue and profits will be essential to sustain the heady gains recently experienced. And so far, there’s little being said about revenue to justify the enthusiasm.”
Then, on July 29, we published a blog asking Is The AI Bubble Finished?, noting “I remain sceptical that all companies with exposure to AI will be profitable. In every past bubble, investors failed to be discerning, assuming all companies would win. That has never been the case. Any close examination of AI’s potential today reveals that unless you’re Nvidia, selling the tech for all the other AI hopefuls, and doing so with virtually no competition, the immediate benefits of generative AI remain limited. And that will limit price gains, too.”
Correcting History
- The largest single-day percentage declines for the S&P 500 and Dow Jones Industrial Average both occurred on October 19, 1987 with the S&P 500 falling by 20.5 percent and the Dow falling by 22.6 percent.
- Two of the four largest percentage declines for the Dow occurred on consecutive days — October 28 and 29 in 1929. The market fell roughly 25 percent over those two days.
- The Dow Jones reached an all-time high in September 1929 before the crash and did not return to its pre-crash high until 25 years later in November 1954.
- From its peak in September 1929, the Dow Jones fell 89 percent, bottoming in the summer of 1932 at 41.22, the lowest closing level of the 20th century.
- The six largest single-day point declines for the Dow Jones all occurred in the first six months of 2020 as investors grappled with the impact of the COVID-19 pandemic.
- The largest single-day point decline for the Dow Jones occurred on March 16, 2020, when the index fell 2,997 points, or 12.9 percent.
- The largest single-day point decline for the S&P 500 also occurred on March 16, 2020, falling 324.9 points, or about 12 percent.
A big part of the last few days’ selloff has been the result of investors realising the stock prices of many megacap tech companies, fuelled by AI hype, had simply run far ahead of AI revenues and profits. Of course, such hype-fuelled bubbles are common, and a few decades of experience permits one to recognise them relatively easily.
The story, however, is not over. If prices fall far enough, they will represent great value again and it’s worth keeping in mind many of these companies will eventually find ways to make their AI investments pay. As I noted in the July 29 blog, “Until compelling, practical applications for these (AI) tools, beyond novelties and chatbots, become more widespread, this boom may remain nothing more than a bubble.
“But that doesn’t mean the long-term wave will peter out. The first tech boom—the internet boom [of 1999]—wasn’t wrong; it was just premature. The hype pushed prices ahead of reality, but the reality did eventually emerge.”
And that I believe is what investors need to keep in mind.
Two (maybe three) things to keep in mind during a selloff
First, the U.S. tech companies leading the markets lower now are seriously extraordinary businesses. As I have written elsewhere, their P/E multiples reflect some fundamental truths about the U.S. versus the rest of the world. And these truths may be perceived as even more valuable amid the threat of heightened geopolitical tensions. They include America being the largest economy in the world (and more resilient because exports account for only 12 per cent of gross domestic product (GDP), having the most desirable demographics of any developed nation, measurably the most productive labour force, the most arable land of any country, and being the world’s largest exporter of agricultural commodities and the largest producer and exporter of oil and gas. At 20 million barrels per day, the U.S. is the world’s biggest oil producer and exporter, with Saudi Arabia at number two with 12 million.
Having the deepest capital markets and some of the best tertiary institutions in the world has helped the U.S. become the world leader in Research and Development (reportedly spending US$879 billion last year—more than the next five countries combined), which, in turn, has put the U.S. at the forefront of technical innovation.
The businesses that have emerged are the world’s largest and have demonstrated the extraordinary ability to increase their returns on equity as they grow their equity base. That’s akin to a bank account earning higher and higher interest rates as its balance rises. Such businesses have broken the preconceived limits of the microeconomics taught at business schools for decades.
The second thing worth noticing is that as megacap technology companies surged, they left innovative and fast-growing small-cap companies behind. Over the last year, the Nasdaq index has risen just under 20 per cent. Meanwhile the small cap indices – the Russell 2000 and S&P 600 have risen just seven per cent and six per cent respectively. But looked at over the last month, the Nasdaq has fallen 11.73 per cent, while the Russell 2000 and S&P 600 have actually risen 0.61 per cent and 1.87 per cent respectively.
That difference suggests some rotation of funds has occurred, out of the Nasdaq and into small caps.
Nobody knows whether a much larger sell-off has just begun or whether a bounce and a resumption of the previous bull market ensues. Some analysts and hedge fund billionaires suggest we are on the cusp of a 1987-style crash. In 1987 the U.S. market fell 20 per cent in a single day, but that was exacerbated by flawed automated trading systems that don’t exist today. In any case, an ’87 crash might not be so bad, remembering the market decline was confined to markets. The 1987 crash did not become a broader financial crisis, and the U.S. market recovered all of the 1987 losses in about four years. For those who added to their investments after the 1987 sell-off they enjoyed returns of over 10 per cent per annum for the next four years.
And that’s the third and final thing to remember, irrespective of what Chinese characters make up the word ‘crisis’, a market crisis does indeed present opportunity.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
