September is living up to its reputation for weakness. Last week stocks suffered their worst one-day pullback since the summer, although markets did stabilize on Friday.
Market news headlines attributed Thursday’s decline to a number of reasons (take your pick): Apple’s supply chain problems, a weak durable goods report and the potential for a Russian retaliation to Europe’s sanctions.
In my opinion, as I write in my new weekly commentary, there was no significant or obvious catalyst for the sell-off. Instead, Thursday’s weakness appears to have been a case of lingering geopolitical risks running into market complacency and some stretched valuations.
But while I don’t believe that the sell-off reflects a fundamental shift in market conditions, it does provide two important lessons for investors.
Volatility is starting to rise. As investors begin to prepare for the Federal Reserve (Fed)’s first rate hike, volatility is starting to normalize. To be sure, volatility is still low by historical standards. During Thursday’s sell-off, the VIX peaked at around 16, still 20% below the long-term average. But an impending rate hike and slightly less benign credit conditions are having the predictable impact of nudging volatility higher.
Valuations are likely to matter more as markets become less driven by momentum. While equities in general have been struggling since the S&P 500 Index first crossed the 2,000 threshold in late August, various market segments are behaving differently. In a sign that investors are paying closer attention to the importance of relative value, segments that still appear to be relative bargains are outperforming those with more expensive valuations.
Case in point: While U.S. large caps, as measured by the S&P 500 Index, are down barely 2% from their peak, small cap stocks, as reflected through the Russell 2000 Index, have never managed to eclipse their February top and are now down roughly 8% from their summer highs.
One of the reasons small cap names have been struggling is that their valuations are considerably more stretched than their large cap cousins. Based on current earnings, U.S. small cap stocks trade at around a 60% premium to large caps. That large premium – a result of a multi-year momentum trade – appears to be hurting the sector.