Equity Markets Hits a Snag as Investors Re-Assess Their Exposure To Technology Stocks

Written by: Kevin McCreadie | AGF

The rally in equity markets has hit a snag as investors re-assess their exposure to technology stocks.  AGF’s CEO and Chief Investment Officer explains why the recent weakness may usher in a period of growing volatility marked by muted returns and minor pullbacks.    

Equity markets have hit a rough patch recently with technology stocks, in particular, taking a hit. What’s behind the increase in volatility?

It’s no secret that the rally off the March bottom has been driven by a handful of big tech names that have vastly outperformed the broader cap-weighted indexes in the United States. And, of course, most of these companies have reaped a benefit from the economic lockdown, while other sectors of the economy have suffered greatly. But as the recovery begins to take hold—albeit tenuously—investors are starting to wonder whether the growth rates of some tech companies can stay on pace to support valuations that, in many cases, have climbed to extreme levels in recent weeks. Take businesses that include video conferencing as part of their services, for example, or those focused on e-commerce solutions. They were critical in allowing societies to function during the lockdown and generated terrific growth, but what happens to their revenue streams if life eventually picks up where it left off when the pandemic hit? Can sales be maintained at the current rate—or even accelerate from here—or will they begin to taper off? And what does a ratchetting up of tensions between the U.S. and China do to the tech sector given the latter’s importance to supply chains and end-market demand? At this point in time it’s not clear, but these are the types of questions now being asked by investors and parts of the market are likely to remain volatile for as long as they remain unanswered.

Conversely, many of the companies that have been impacted negatively by the pandemic could stand to gain from a recovering economy. How does this affect the potential direction that markets take from here?

Ideally, it should give a boost to markets overall as beaten-down cyclical stocks are bid up on the prospects of better economic conditions and these gains help offset some of the expected weakness or flattening out in ‘growthier’ tech names that we’ve already discussed. But that may not be exactly how this unfolds given some of the unique aspects of the current environment. Investors who are “over-indexed” by having large exposure to cap-weighted benchmarks like the S&P 500 Index, for instance, are more susceptible to tech stocks selling off because of the sheer weight these names now carry in these indexes. At the same time, those whose portfolios are more reflective of equal-weighted indexes won’t be hit as hard and may benefit in greater proportion from a subsequent climb in cyclical names. It’s also unclear how neatly and tidily a market rotation of this kind would play out. After all, tech stocks may be due for a larger correction even if the recovery stalls and today’s stay-at-home environment persists, but cyclical parts of the market are likely to rebound—at least in a prolonged meaningful way—only when there are surer signs of sustained economic growth going forward.  Moreover, it remains to be seen what effect the massive increase in retail, self-directed investment over the past few months will have on this rotation. Will the selling of names these investors have loaded up on force them to exit the market altogether or will they stick around and find new opportunities to put their money to work? Again, there’s just a lot of different variables at stake, which makes it that much more difficult to envision a clear path for markets one way or the other.   

In other words, expect even more volatility ahead? 

I think that’s right. We may be in for a stretch of muted returns offset by minor pullbacks. Many of the catalysts fueling the equity market rally earlier this summer may already be fully priced in, especially the prospects of a vaccine being approved later this year or early next. At the same time, we’re in a bit of a lag regarding the release of economic data like third quarter GDP, which could provide a lift if surprising to the upside, and it’s increasingly uncertain whether significant new stimulus measures are actually forthcoming despite them being talked about for months. The risk, meanwhile, of a second COVID-19 wave and economic setback can’t be dismissed with schools back in session and case numbers rising in several countries. Then, of course, there’s the looming U.S. election that may end up being the biggest risk of all. Investors need to be ready for the possibility of a disputed result that upends markets and further fuels the country’s deepening social divide. So, unlike the fairly steady and outsized returns since the lockdown, we expect choppier markets ahead as we move through the fall.  Equities may experience significant day-to-day volatility and remain range-bound until clarity on these issues—and how they are resolved—becomes apparent.

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