Ding! Ding! Ding! As the opening bell rings, it is as if we are watching a boxing match between the bull and the bear. On one side we have the optimistic bulls while on the other side we have the pessimistic bears. At the end of the day, the victor shall determine if the market is red or green.
Last week, as the stock market continued to drop from its high, we could see the clear victor of the boxing match. The bears. Over the last trading week, we could see the bloodbath of the match. A sea of reds as stock prices continue to drop.
While the general market has been dropping, you may notice that growth stocks (eg. Apple, Tesla Inc, Shopify) have decreased much more than value stocks (eg. Procter & Gamble, Johnson & Johnson, and Berkshire Hathaway) last week.
So, what happened? Why did the market drop and why did it affect growth stock more. Well, this could be the result of rising treasury yield in the US.
Rising treasury yields
As of 25 Feb 2021, the 10Yr Treasury yield is at 1.54%.
Compared to the start of the year when yields were at 0.93%, it has increased by 60 basis point. If you look at the 2Yr treasury yield which has only increased by 6 basis points, the 10Yr Treasury yield has increased sharply.
*Treasuries are government debt that pays a certain yield in return for you holding it.
This sharp increase in longer-term treasury yield as compared to shorter tern treasury yield has resulted in the steepening of the yield curve, as shown on the graph below.
A steepening yield curve can be attributed to investors’ expectations of strong economic growth. This phenomenon arises due to the positive sentiment of the US economy reopening as vaccines start to roll out together with the news of the next stimulus package.
Well, isn’t it great that investors are expecting stronger economic growth? With stronger economic growth, the market should be positive right?
Well, not the case.
Don’t forget that the economy is not the stock market. In fact, in the backdrop of strong economic growth, inflation lurks. It is the expectation of this inflation (and the potential rise in interest rate to curb inflation) that cause many investors to worry and lead to the massive sell-off in the market, especially growth stock.
Why specifically growth stock?
Well, you see, most growth stocks are valued base on the present value of the companies’ future cash flows, a rise in inflation and interest rate would essentially reduce a company’s present value as a higher rate of inflation has to be taken into account. In layman’s terms, with the rising interest rate, the company is not worth as much as it is since the money generated by the company in the future is worth less in today’s money. This expectation contributed to the sharp decline in tech stocks last week.
So that’s the general idea of why the market had a sell-off last week.
What to do going forward
If you are invested in the stock market and have been overly concentrated on tech stocks, you would have seen a huge drawdown in your portfolio. While there is nothing you could do now other than to wait for the share price to recover (and it will), here are some lessons learnt going forward.
- Diversify your holdings
Review your portfolio from time to time. Ensure that your stock holdings are not overly concentrated in one sector, industry, or country. By diversifying your holdings, you will reduce potential drawdowns in the event one sector is down in the case of tech stocks in this scenario.
- Keep a war chest
During market downturns, it is the only time you will see a massive sale in the market. As an investor, this is usually the best time to enter the stock at a discount. By having a war chest, you would have additional money set aside to buy into the stocks.
- Stay Calm
It is normal to panic when you see unrealized loss increase every day. However, don’t panic, as Warren Buffet once said, ‘The stock market is a device for transferring money from the impatient to the patient’. If you believe the stock you bought has good fundamentals, hold on to it.
Eventually, the price will recover in the long run.
Appendix
As an investor, we should not predict where the market would go. However, by using signals, it could better prepare our portfolios for downturns. If you are interested to learn how to use the yield curve to aid you, continue reading.
What’s a yield curve?
A yield curve is the yield of all the treasury bonds with different maturity plotted on a graph. It provides a clear view of the yield of short-term and long-term bonds.
In general, the longer-term treasuries will yield more as investors holding these treasuries would like to be compensated with a higher yield for holding on for a longer period. As a result, the yield curve typically slopes upwards.
The yield curve is not static. Instead, it moves according to market sentiment. When investors don’t see attractive investment options in the equities market, they tend to move it to safe havens like treasuries. Higher demand leads to a drop in yield. Conversely, when there is a lesser demand for treasuries bonds, its yield rise.
Flatten yield curve
While a general upward slope is common, at times we do see the yield curve flatten. A flattening yield could be a result of certain factors. It can be due to the expectation of future inflation to fall or the expectation of slower economic growth. With inflation being less of a concern, the premium for long term treasuries falls with it, resulting in a flattened curve
Inverted yield curve
On rare occasions, we could also see an inverted yield curve where short-term treasuries are yielding much higher than longer-term treasuries. This is the result of investors believing a recession is coming hence wouldn’t mind a low yield for the longer-term treasury. Historically, an inverted curve has often preceded a period of recession.
10 minus 2-year treasury yield spread
Another way investor uses the yield curve would be to plot the spread between the 10Yr yield and the 2Yr yield. What you can see from the chat is that whenever the line dips into the negative, a recession which is denoted by the shaded area precede. You see this during the 2000 dot com bubble, the 2008 financial crisis, and the previous Covid-19 crash.
This is pretty interesting, and you could consider using this as an indicator. Though I have to say, it is not a perfect indicator as we see between 1990 to 2000, there was twice where the line dip close to zero, but a recession did not happen.
To find out more about Yield Curve, you can start with this video.