Emphasize consistency to navigate volatility

In this article, Russ Koesterich looks at the direction reversal and market sell-off seen in recent weeks and shares his thoughts on why a focus on stocks with strong fundamentals is warranted.

It started in mid-July as a rotation from crowded tech names to under-owned US small caps. The spin quickly turned into something worse: a large risk-free trade. While the worst damage was in semiconductors and other tech names, by Monday, August 5, the broader stock indexes were down nearly -10% from their recent peak.

This may raise the question of why a routine change in market leadership turns into a quick and violent sell-off? I believe several factors contributed, including a sudden reversal in the Japanese yen, which had been the source of funding for many risky trades, as well as the extreme crowding of several AI-themed names. But the main catalyst it was a pair of weak economic prints that raised recession fears. The good news: As the economy normalizes from a bloated post-pandemic growth rate, a recession (i.e. negative growth) does not appear imminent.

Return to normal growth, not recession

Ironically, market volatility began to increase in mid-July, coinciding with the shift to US small caps and regional banks. At the time, I was surprised by the move. Buying highly cyclical stocks in a well-telegraphed growth slowdown seemed like an odd trade. As it turns out, it didn’t last long. Investor enthusiasm for riskier stocks quickly dissipated as recession fears grew.

While an economic slowdown is evident in the data, a recession is less certain. The recent ISM report on manufacturing was weak, but manufacturing has been struggling since early 2022 and is not a major driver of the current economy. In contrast, the much larger services sector is growing at a reasonable pace, as evidenced by the July ISM Services figures.

In addition to tepid manufacturing, investors were also spooked by recent labor market numbers. While July’s headline number was weak, the labor market is normalizing and not collapsing. The increase in the unemployment rate was a function of higher labor force participation. The slowdown in job growth is a return to a more sustainable level after several years of above-trend growth. The three-month average of net new jobs is around 170,000, consistent with modest economic growth.

Higher volatility underscores the need for quality

However, while I think recession fears are overblown, I am sympathetic to investors’ concerns. Growth is slowing, seasonality is turning negative, and if history is any guide, the upcoming election could be accompanied by rising volatility.

To be clear, this suggests managing risk exposure, not abandoning stocks. The stock performed well in the first half of the year, but unlike in 2023, gains were fueled by higher earnings, not multiple expansion (see Chart 1). A trend that I think could continue in the second half of the year.

Diagram 1 (Equity sources of total return – to date)

Instead of dramatically reducing equity exposure, I would suggest a two-pronged strategy: reducing equities and moderate cyclical exposure in favor of more stable companies. This approach would suggest emphasizing stocks with consistent fundamentals: stable revenues, earnings and margins. Many of these companies are found in pharmaceuticals, energy-related infrastructure, as well as software and high-end consumer companies. Looking ahead, I still think equity markets can end the year higher, albeit with a few volatile days between now and November.

This post originally appeared on iShares Market Insights.