Stocks Struggle as U.S. Economy Continues to Disappoint
Stocks lost ground last week, despite some positive news: The announcement of the largest merger of the year between Heinz and Kraft and more evidence of economic improvement in Europe. Nonetheless, most global benchmarks were down between 1% and 2%. In the U.S., the S&P 500 Index fell 2.23% to 2,061, the Dow Jones Industrial Average dropped 2.29% to 17,712, and the Nasdaq Composite Index lost 2.69% to close the week at 5,026. More signs of investor skittishness: For the week ended March 25, investors withdrew $11 billion from equity funds. As for bonds, the yield on the 10-year Treasury rose slightly from 1.93% to 1.96% as its price correspondingly fell.Investors continue to wrestle with disappointing U.S. economic numbers—lastweek it was a weak durable goods report—and soft company earnings. But while the losses were across the board last week, the recent sell-off and pickup in volatility serve as a useful reminder of the risks lurking in some areas of the market. This was particularly true among the so-called momentum stocks—as well as some that have been acting that way.
Hello Again, Volatility
Not surprisingly, as stocks corrected, volatility spiked. While volatility remains below the long-term average, it is on the rise from last summer’s historically low levels. Last week the VIX Index, a common measure of stock market volatility, traded as high as 17, which was 35% above the week’s low. We see a similar phenomenon in bond markets, where volatility has pulled back somewhat from the February high, but is up around 65% from last summer’s lows, as measured by the MOVE Index.
Financial market volatility has been on the rise due to somewhat mundane issues: slower economic growth, disappointing earnings and anticipation of an eventual rate hike by the Federal Reserve (Fed). Meanwhile, there may be a potentially bigger risk lurking that investors seem to be dismissing for the time being: Greece.
Last week, investors looked past Greece’s unresolved issues and bid up Greek bonds. However, time is running out for the country, which faces a serious cash crunch as early as April 9 when it is scheduled to make a 400 million euro payment to the International Monetary Fund. It is still not clear where the money to make the payment might come from. In order to unlock previously agreed upon loans from the European Union, Greece must submit a comprehensive proposal of economic and structural reforms, which it has yet to do. Even if the government does manage to submit an acceptable set of reforms, it is not clear that the governing coalition will be able to hold together and get the reforms passed by the Greek parliament.
In short, Greece could be facing a serious crisis. Yet there is little evidence that investors are overly concerned about the potential ramifications: that Greece might exit the eurozone or the risks spread to peripheral countries. While a Greek exit is still not our base case scenario—another last minute compromise is the most likely outcome—the risks are rising. With volatility still below average, there is a lot of room for it to rise should there be an actual catalyst.
Caution on Momentum Stocks of All Shapes and Sizes
Greece aside, the rise in volatility represents a relatively normal adjustment. And while an uptick in volatility doesn’t herald an end to the bull market, it does imply that investors may want to revisit their investment positioning.
Last week was illustrative. The rise in volatility had a predictable impact: Stocks that are most expensive and have been driven by momentum were the hardest hit. One case in point is biotech. Through the close of the week ended March 20, the Nasdaq Biotech Index had surged 20% year-to-date. Last week, despite the relatively modest pullback in stocks, the Nasdaq Biotech Index fell roughly 5%.
Biotech is an obvious example of the momentum trade. It is a high “beta” or risky industry that has been a strong relative performer for many years. But there are also less obvious momentum names. As we have pointed out in recent weeks, yield plays were some of the best-performing stocks last year. While investors don’t typically think of these as “momentum” names, their relative valuations are stretched and, like biotech, they have benefited from a steady stream of money into the space. These stocks—utilities, for example—warrant caution as well.
