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Portfolio > Economy & Markets > Stocks

4 Market Sectors Vulnerable to a Correction

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U.S. equity markets recently reached new highs and riskier segments of the bond market are also thriving against an economic backdrop of moderate growth, low interest rates and low inflation. However, investors may be getting lulled into a false sense of security given the economic expansion and relatively muted volatility over recent years. 

Investors have crowded into certain investments and may be overly complacent about the risk of a correction in some of the most popular segments of the market.  For example, high-yield and emerging markets bonds have been appealing destinations for investors frustrated by the low yields available from government and investment-grade corporate bonds.

However, some holdings within high-yield and emerging markets debt may be vulnerable to economic turbulence or changes in sentiment. Dividend-oriented stocks such as utilities have also been popular as bond substitutes, but could lose ground if interest rates rise. “Platform” stocks such Facebook, Amazon, Netflix and Google (“FANGs”) that are providing rapid revenue and earnings growth have been the destination of choice for many investors who find themselves starved for portfolio growth.

Slowing growth, rising rates or simple changes in sentiment could create a correction in one or more of these market segments. Advisors should consider the risks and assess whether portfolio modifications are necessary to preserve the gains of recent years.

FANGs and other platform stocks may not grow indefinitely.

Platform companies such as the FANGs, Apple and Microsoft provide an “ecosystem” in which companies plug into the platform to add incremental value or gain access to a network of potential customers. The network effects from successful platforms create “winner take all” or “winner take most” economic models that are difficult to compete against. 

However, platform stocks may not have uninterrupted momentum. Amazon and Netflix have sky-high valuations, with Amazon trading above 200 times estimated earnings for next year and Netflix at more than 100 time earnings. Any deceleration in Amazon’s growth trajectory would be a potential catalyst for the stock to fall, as doubts about the company’s ability to growth profitability enough to “justify” its valuation multiple. Netflix may also face challenges growing into its valuation, given that Disney is among the content providers expending considerable resources to challenge the Netflix platform. Antitrust considerations are a growing concern for Facebook and Google, as the European Commission scrutinizes both companies with a high degree of skepticism. Although Facebook, Amazon, Netflix and Google are great companies, it isn’t a given that they will each be great stocks to own in the future.  

High-yield bonds offer a tempting yield premium over less-risky debt, but some investors may be getting carried away.

One of this year’s highest-profile debt offerings provides evidence that investors may be underestimating potential risks. In May, Netflix issued more than 1 billion euros of bonds with a 1-year maturity and coupon rate of 3.625%. Netflix is projected to have $2 billion of negative cash flow this year and faces considerable potential competition over the next 10 years. It’s logical to wonder whether Netflix bondholders are being appropriately compensated for their risk, yet the deal was three times oversubscribed.

Tesla’s $1.5 billion bond offering also turned some heads, given the uncertain outlook for a company that had more than $1 billion of negative cash flow in the second quarter. The energy sector continues to present elevated risk in the high-yield market, given the pressure on oil prices because of the supply growth from horizontal fracking and competitive threats from renewable energy. Popular high-yield ETFs have considerable energy exposure. For example, the nearly $19 billion in assets iShares iBoxx High Yield Corporate Bond ETF (HYG) has more than 12% of portfolio assets invested in energy sector bonds.

Investors in emerging markets bonds may also be overly enthusiastic in their reach for yield. 

One of this year’s highest profile deals was Argentina’s oversubscribed $2.75 billion offering of a 100-year bond. Argentina has defaulted on its debts five times in the last 100 years, and has spent 75 years of its two-century history in default!

Although Argentina under President Mauricio Macri has made tremendous progress unwinding the disastrous economic policies of Cristina Kirchner, it may be premature to assume that Argentina’s leaders will continue to pursue pro-market policies for the next century. Despite positive economic steps, Argentina today has a high level of U.S. dollar-denominated debt, leaving the government’s balance sheet vulnerable to a decline in the peso and raising the risk of a fiscal crisis over a three- to five-year horizon.  

Dividend-paying stocks offer higher yields than most bonds, but utilities and many consumer staples stocks have high valuations and low growth rates.

Bonds may become more attractive if interest rates continue their recent rise, and utilities and staples stocks may suffer in a rising rate environment. Utilities stocks may be the most vulnerable, given slow growth, high leverage and cash flows that for some companies is not sufficient to fully cover dividend payments. The utilities sector of the S&P 500 index is trading at nearly 18 times earnings, nearly a 10-year high and considerably above the 20-year average for the sector. Some dividend-oriented ETFs are also reliant on income from utilities stocks. Notably, the $17 billion iShares Select Dividend ETF (DVY) has approximately 30% of its assets invested in utilities stocks.

Consumer staples stocks also benefit from investor appetite for income as well as the perception of stable cash flow and low volatility. Stocks such as Procter & Gamble, PepsiCo, Coca-Cola and McDonald’s are all selling at comparatively high earnings multiples but face significant growth challenges. If rates rise, the market may turn to companies better able to grow earnings and dividends.

The “Goldilocks” economy — not too hot, not too cold — provides a foundation for the bull market to continue and could support a continuation of the themes that have been popular in recent years. However, given the elevated valuations of stocks and bonds in the U.S. coupled with the gradual normalization of monetary policy by the Federal Reserve, the risk of a reversal of these popular themes is a possibility that shouldn’t be ignored.  

A quote from famed investor Howard Marks may be instructive: “You want to take risk when others are fleeing from it, not when they’re competing with you to do so.” Selectivity is critical, particularly after a long bull market. 


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