Issue 91: Tech Stocks Sell Off

This Week’s Highlights

• Sentiment wavers in tech sell-off
  The last couple weeks have witnessed bigtime volatility in tech stocks, exemplified by a peak-to-trough plunge of almost 13% in shares of semiconductor bellwether Nvidia. Despite a rebound in NVDA over the rest of the week, the wild swings left investors worrying about bursting bubbles.
• US homebuyers feeling the pain
  May data from the National Association of Realtors saw US pending home sales—a leading indicator of existing home sales—defying analysts’ forecast of a gain and dropping to their lowest level on record, as high mortgage rates and lofty home prices made it harder to strike a deal.
• Dollar strength hurting EM stocks
  Reviewing the historical data on USD strength and emerging markets equity weakness, it’s not surprising that EM countries and firms issuing dollar-denominated debt and selling commodities settled in USD have struggled as tight Fed policy pushed the greenback to a two-decade high.

The CIO’s Take:

• While we’ve taken a sell-off in tech stocks over recent weeks in stride, that volatility has clearly shaken the faith of some investors in the AI revolution. Valuations seem stretched—and that contributes to the turbulence, in our view—though we see strong fundamentals in specific stocks and still find opportunities for our active approach.
• Speaking of active tilts, investors with sector exposure to the US housing market will have been shocked last week by softer-than-expected activity on home sales. We see that weakness receding over time as rates inevitably come down (albeit on a long delay) and high prices eventually give way to more robust inventory.
• Anyone following our models and commentary will know we’re believers in the present opportunity posed by cheap EM stocks. Although our central thesis is around growth, valuation, and behavioral alpha, a potential tactical tailwind is eventual weakening of the dollar, something historically associated with EM outperformance.

Nvidia sheds nearly $300B in value

Last week, NVDA extended its slide from an all-time high registered on June 18th. At the close of trading on June 24th, the semiconductor mega-cap had fallen almost 13% from its peak, putting its shares firmly in ‘correction’ territory. The stock rebounded over the next few days, though at Friday’s close, its valuation was still almost $300 billion lower than it had been at the top. For some perspective on the size of that loss, we note that the drop in Nvidia’s market cap was bigger than the total size of rival chipmaker AMD, not to mention some well-known blue chip names (see below).

Investors should get used to the volatility
So, what happened to drive such a massive swing in market cap? There isn’t anything like a smoking gun in this case. Chalk it up to volatility—which reflects down as well as up moves—and profit taking: the torchbearer of the AI revolution has been carrying the S&P 500 in 2024, accounting for roughly one-third of the index’s year-to-date increase and, despite the drawdown, has created over $1.8 trillion in value for shareholders. Indeed, it was recently reported the firm is having retention problems with engineers retiring early on profits from stock and options grants.

Tech firms especially prone to swings
We would argue moves like NVDA’s recent drawdown shouldn’t come as too great a shock to investors. Particularly in the case of tech stocks, for which much of a firm’s valuation derives not from current profits but expectations for uncertain future growth, even small changes in beliefs about Fed policy or future opportunities for an industry’s expansion are amplified. Moreover, with valuations as stretched as they are today on AI optimism, sentiment is likely to be especially sensitive, making the sectors recently capturing so much attention more susceptible to such swings.

Gauging the ‘bubble risk’ in US stocks
Despite this perspective on volatility, we don’t blame investors for asking a question we’ve heard swirling amidst the recent tech sell-off: Are US stocks in a bubble? Valuations have risen sharply for a concentrated group of stocks over a relatively short time, to be sure. On the other hand, growth in tech earnings has been strong, and we haven’t seen prices truly decouple from fundamentals like we witnessed in the late-90s dot-com bubble. At the end of the day, we can see the current rally continuing, but believe an active approach could help mitigate the painful ups and downs.

Struggling US Home Sales

May pending sales fall to all-time low
It’s been a while since we opined on the US housing market, and last week brought some data that drill home rather extreme conditions brewing in the property sector as of late. On Thursday, the National Association of Realtors (NAR) released data on home sales for the month of May, showing contract activity falling 2.1% from the month prior, significantly worse than the 0.5% increase analysts had been expecting. That represented a 6.6% year-over-year drop, bringing the pending home sales index to its lowest level since NAR began tracking activity way back in 2001 (see below).

Low affordability holds back buyers
Underlying the dismal stats is a confluence of two unfavorable trends: Restrictive Fed policy has pushed 30-year mortgage rates to nosebleed levels, hovering around 7% today, more than double the level borrowers faced before rate hikes began. Meanwhile, home prices—hit by inflation in construction materials and a pandemic shock to demand—remain elevated, with selling prices hitting another record in May, at over $419K. The combination of high rates and home prices has put a damper on affordability and kept many homebuyers out of the market.

Change will come—but takes a while
There is reason to be hopeful in the longer term. For one thing, inventory is apparently rising, as NAR Chief Economist Lawrence Yun noted last week. Yun cited May’s existing home supply rising 18% year-over-year, which he expects to raise the level of homebuying in a job-creating economy. On top of that, although we were among the first to predict delays in the Fed’s rate cut timeline, we don’t doubt that policy will eventually loosen, leading to lower mortgage rates and another obvious catalyst for a rebound. That said, anyone expecting sudden a change is likely to be disappointed.

The Dollar vs. EM Stocks

Why focus on moves in the dollar?
If it seems that our commentary is unduly focused on the US, that’s because action in the world’s largest economy has a big impact on what happens internationally. That certainly goes for the dollar, still the world’s reserve currency. And while we don’t have space here to get into all the ramifications movements in the greenback have for governments, companies, and economies around the world, we wanted to say a few words here about the impact dollar strength has on EM stocks, an asset class we’ve often discussed as presenting a compelling opportunity to investors.

Stronger dollar, weaker EM stocks
It turns out that impact is substantial (see below). There are at least a couple reasons US dollar strength tends to correspond with weaker EM equity returns. For one thing, most EM states and firms issue debt in USD given the riskiness of their local currencies; the upshot is that when the dollar appreciates, that debt gets more expensive to service, creating significant economic strain. For another, because many EM countries are net commodity exporters, a stronger dollar makes those exports more expensive, decreasing demand and hurting those countries’ and companies’ profits.

Where is the greenback going?
Although the US dollar often appreciates during stress periods due to its ‘safe haven’ status, the primary driver of recent dollar strength observed in the chart above has been Fed tightening, which increased demand for dollars as investors flocked to Treasuries. Where is the dollar likely to trend going forward? In an election year, we expect more pronounced volatility, though ultimately, the Fed will cut rates, at which point we expect the dollar to weaken. In our view, that represents a very obvious potential tailwind for EM stocks—one more reason we favor them now.

FX exposure through an active lens
Another important consideration, and something we often talk about in the context of emerging markets: the basket of EM economies is a remarkably heterogeneous one. The dollar index depicted above is an attempt to gauge the strength of USD against a set of the world’s most important currencies, but not all emerging markets face the same FX risk relative to the dollar. Moreover, individual companies vary in terms of their dollar exposure—export-oriented firms, for example—and these differences are all subject to consideration when building an active EM portfolio.