Tech Giants Stumble: Navigating Opportunities in a Shifting Market

16 aug. 2024

Dear Investors,

Recent developments in the U.S. economy have raised concerns, as a disappointing Consumer Price Index (CPI) report and a weakening economic outlook contribute to growing uncertainty. Unemployment has reached 4%, which has negatively impacted consumer sentiment and spending. As a result, markets adopted a cautious stance around mid-July, leading to only a modest gain of 0.64% in developed markets for July.

Although the most recent retail sales and jobless claims reports have cast doubt on the perceived weakness in the U.S. labour market, these earlier reports had convinced investors that the Federal Reserve will soon lower interest rates. This anticipation boosted the performance of interest-rate-sensitive small-cap stocks throughout July. Surprisingly, however, growth stocks—typically expected to benefit from falling interest rates due to their potential for future profits—underperformed. This was largely due to disappointing earnings reports from four of the "Magnificent Seven" tech giants, which raised doubts about the expected returns from artificial intelligence investments and led to a decline in their valuations.

An equally-weighted composite of the "Magnificent Seven" experienced a significant drawdown of approximately 18.3% from its peak on July 10th to its recent low on August 7th. As concerns over the future earnings of these tech giants heightened risk aversion, valuations of all growth stocks (Nasdaq, -14.4%) and the broader market (MSCI World, -7.6%) declined. Despite this correction, Vector Navigator demonstrated remarkable resilience, recording a loss of just 5.2% during this period.

Vector Navigator has increasingly become a defensive choice for investors as major tech stock valuations reach unprecedented levels. Analysing the 20-day drawdown period from July 10th to August 7th, we observed that on the seven days when the "Magnificent Seven" outperformed the MSCI World, Vector Navigator underperformed by only 1.0%. Conversely, on the 13 days where they underperformed the market, Vector Navigator outperformed the MSCI World by 3.4%, showcasing the potential for significant gains for Vector Navigator should the technology sector further deflate. Additionally, Navigator underperformed the market by 0.6% on days when the market rose (8 days), but outperformed by 3% on days when the market fell (12 days).

Extending this analysis from 2021 to 2024 reveals a consistent pattern: Vector underperformed during rising markets (-10.0% per annum) and when the "Magnificent Seven" outperformed the broader index (-12.9% per annum). However, Vector excels during market downturns (+10.2% per annum) and when the MAG7 underperform the index (+9.8%). This similarity is unsurprising, as falling markets have become increasingly correlated with relative underperformance of the "Magnificent Seven" compared to the broader market.

These observations highlight a crucial shift: mega-cap stocks, which once served as a safe haven during market downturns, currently no longer offer the same protection due to their inflated valuations driven by the AI-related bull market. Historically, from 1926 to 2024 in the United States, large-cap stocks have outperformed the broader market during downturns due to their perceived stability, characterized by steady cash flows and strong balance sheets. In contrast, growth stocks – which have become the largest companies worldwide over the past decade - are more susceptible to fluctuations in earnings expectations and investor sentiment, often underperform during market corrections—right when it affects investors the most.

The accompanying graph illustrates the U.S. market drawdown (orange) since 1926 and the additional drawdown for growth stocks compared to the market (blue, where positive/negative values indicate greater/lower excess drawdown). The excess drawdown clearly concentrates around market corrections and extends beyond events like the dot-com bubble. Because these drawdowns occur in negative markets, the returns needed to catch up to the index far exceed the excess drawdown shown below.

Investors who prioritize valuations and fundamentals should recognize the inflated prices of major indexes and mega-cap growth stocks, coupled with increasing market volatility, as a cautionary signal. It is crucial not to allocate capital blindly to ETFs, which often allocate more than 20% of their assets under management to the “Magnificent Seven.” Instead, investors should seek value in investment styles that have been overlooked during the past decade and may benefit from the rotation away from this decade’s biggest winners. This approach should be considered before quantitative strategies regain popularity and drive up the prices of small and mid-caps that have been easily forgotten while the AI boom potentially falters.

Best regards,

Werner, Thierry, & Nils