Cruise Control Works Until You Hit Traffic

Cruise control or “auto cruise” was created to automatically control the speed of a motor vehicle. As the system takes over the throttle of a vehicle, it helps to maintain a steady speed so that a driver can better focus on the road ahead. Cruise control can be especially useful for long drives, reducing driver fatigue, helping the driver avoid exceeding speed limits, and improving fuel efficiency. However, it’s not designed for challenging road conditions.

In recent years, many people chose passive investments for their nest eggs. Like putting your drive on cruise control, investing in a passive/index fund attempts to generate returns consistent with a broad market index, reducing the need for thought and effort to try to outperform. Many of these investors enjoy the cruise control-like features of index funds, because they often come with lower costs, while still providing attractive long-term results.

However, cruise control (even “adaptive” cruise control) fails to work very effectively in stop-and-go traffic. Cruise control can also lead to an increase in accidents, if the driver doesn’t slow down while going around dangerous curves or pays less attention to the conditions around them.

Index funds can also provide many of the same dangers. When the markets narrow, like they have been, and fewer and fewer companies are profitable due to the shutdowns associated with COVID-19, the “cruise” feature of these index funds can put an investor’s money in greater danger. With much of the world economy still in shutdown mode, many curves in the road are forming with index funds.

As the recovery has been unfolding, the Dow, S&P 500, and NASDAQ indices have all rallied significantly, since the March 23 market bottom, lifting almost all companies in these indices. The fact that many investors are buying these broad-based index funds has pushed up the entire market. However, lower earnings and fewer sales may be in the foreseeable future for many of these companies. This means many companies are now worth more than they should be. Now is the time to be paying closer attention to the road conditions up ahead!

Index fund investing has helped propel many companies back near all-time highs. As a result, many bubbles have been forming, particularly in the S&P 500 and NASDAQ 100 markets. Companies like Tesla, Microsoft, Apple, Amazon, and Netflix have seen share prices rise to astronomical levels, despite a reduction in sales. This is a recipe for a crash somewhere down the road.

In the S&P 500, Facebook, Apple, Alphabet (Google), Microsoft, and Amazon now make up over 20% of the index’s returns. If one or more of these companies falters, it could send the S&P 500 off track quickly. This is reminiscent of 1999, when seven technology companies like Cisco Systems, Intel Corp, Microsoft, and Oracle made up over 54% of the S&P 500. Back then, investors blindly drove the S&P 500 higher and higher before technology stocks caused a massive wreck.

The high technology concentration in the S&P 500 today doesn’t mean stocks will crash, but it does expose the danger of leaving one’s investments on “cruise control.” Most investors in the NASDAQ 100 and S&P 500 have been ignoring the warning signs on the narrower road of today’s market.

Though we are optimistic that the economy will eventually recover, we are also realistic that not all recoveries will be created equal. Companies in challenging industries, like retail, restaurants, travel, financial, leisure, energy, and industrial production could see much more challenging conditions in 2020-2021.

The fact that many of these companies have recovered so quickly is setting many investors up for disappointment once they hit bumper-to-bumper traffic with downbeat earnings reports.  Just because most stocks have benefited from a broad rally doesn’t mean they will have a steady ride moving forward. Second-quarter earnings results should be terrible. FactSet Research recently reported second-quarter earnings are expected to plunge by nearly 42% on average. Additionally, sales are expected to plummet by greater than 11% on average. Later quarters in 2020 and even in 2021 could be much worse than expected.

This means fewer and fewer stocks will have positive results. Now is the time to put your hands on the wheel and make sure you are watching your speed and the road ahead. As the road to recovery narrows, our team is prepared for the winding journey in the days ahead. Investors are starting to pay closer attention to the objects ahead and are flocking to companies with superior fundamentals and the ability to prosper during an economic recession. This is the type of market where our team does its best driving.

This doesn’t mean you won’t see sharp twists and turns in the upcoming weeks, nor does it mean it will be a smooth ride moving forward. However, by turning off cruise control and choosing how we selectively invest in this market, we will be better equipped for the congestion up ahead. The stock market road will remain bumpy, twisty, and “turny” over the next few months, as more disappointing economic data is sure to be released. Now is the perfect time to have a great team of drivers and navigators for your financial road trip!

Sources: Yahoo Finance, Reuters.com, and JP Morgan Market Insights

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