The Sell-Off Continues

The sell-off continues... What's behind the rout in tech stocks?... Prepare for more volatility no matter what...

The sell-off in market-leading technology stocks continued today...

The tech-heavy Nasdaq Composite Index fell 1% on Thursday, 1.5% on Friday, and another 1.5% today. All told, the index has shed about 5% over the past three days, compared with just 2% in S&P 500 Index over that period.

This difference in performance is largely a result of weakness in the so-called "FANG" stocks – Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google-parent Alphabet (GOOGL) – and a handful of other high-flying tech companies.

You see, these companies have a much higher relative weighting in the Nasdaq than in the S&P 500. For example, Facebook – which has led to the downside with a 21% decline following disappointing earnings on Wednesday – has a weighting of more than 4% in the Nasdaq but just 1.8% in the S&P. And it's a similar story for Amazon (7.2% vs. 3%), Netflix (1.5% vs. 0.6%), and Alphabet (6.5% vs. 3%).

The sell-off began following Facebook's disappointing earnings announcement Wednesday evening...

The market had shrugged off a weaker-than-expected earnings report from Netflix earlier this month, but not so with Facebook. Shares plunged 20% following news that the company expects growth to slow in the months ahead.

However, as our colleague Austin Root noted on Thursday, the company's slowdown wasn't entirely unexpected... And more important, the long-term fundamental story remains intact.

Likewise, second-quarter earnings from fellow FANG-member Amazon on Friday morning were anything but disappointing. And yet even its shares gave up most of their gains that day, and fell another 2% today.

So what's really behind the decline in these stocks?

It likely has more to do with sentiment than anything else: These stocks have become an incredibly popular and crowded trade lately.

It's not hard to see why... They've trounced the broad market over the past couple of years, and this outperformance has only grown more extreme in recent months. In fact, as we've discussed, just the FANGs – along with Apple (AAPL) and Microsoft (MSFT) – have accounted for the vast majority of the broad market's gains over the past several months.

But this kind of one-sided sentiment extreme can also be dangerous. As we in noted the July 18 Digest...

Today... the long trade in tech stocks is crowded...

This signal doesn't mean these stocks can't continue to lead the market higher. (And as always, we don't suggest making investment decisions based on a single indicator alone.)

But it does suggest that this trade is ripe for at least a short-term reversal, and any hiccups in these stocks could trigger a swift sell-off.

Again, this is not a reason to panic...

In fact, as our colleague Steve Sjuggerud noted last week, history suggests the recent outperformance of high-flying tech stocks is actually a positive sign... It suggests that the final phase of the "Melt Up" could be about to begin.

But it is a reminder that if you're going to stay invested for the Melt Up, you must be prepared for more volatility.

As Steve has noted several times, it won't be a smooth ride higher. During the last Melt Up in the late 1990s, tech stocks suffered five separate declines of 10% or more along the way... which means we could see several more of these sentiment extremes and subsequent sell-offs in the months ahead.

For now, our advice remains: Stay long, but stay "hedged"... and keep a close eye on your trailing stops, just in case.

New 52-week highs (as of 7/27/18): American Express (AXP).

In today's mailbag: More on the most dangerous phrase in finance... two subscribers weigh in on Friday's Digest from our colleague Bryan Beach... and more on "Kiz." Send your notes to feedback@stansberryresearch.com.

"'This Time Is Different' – NOT. So the Fed thinks the term premium is low, most likely due to large central bank bond purchases to prop up their economies. Yet the Fed is unwinding those purchases, which should mean the term premium rises too. If so, then they really don't need to be raising short term rates because they are already withdrawing support for the economy which will slow things down in itself. Seems they are double attacking the growing economy. That's the problem with Fed manipulation of the markets – so many unintended consequences." – Paid-up subscriber Rob C.

"Bryan Beach's Digest (Friday, July 27) is (one of) the very best that I've read. I'm not good with words, but I am deeply impressed Bryan, with your honesty, writing ability, insight, and integrity. You have taught us how to profit, not just with investing, but by making the best of our experiences. I totally agree that report cards do not tell the whole story, but the important thing is how you view your own achievements... and your own self-confidence. Wow. What talent!" – Paid-up subscriber Sue M.

"Bryan, I admire your candor as well as your skills. Your recommendation to write down your reasons and expectations are spot on. I don't always do that and often wonder what I could do differently. It took many years for me to realize that all investments are temporary and you should get rid of them at some point in the future. The obvious reason is if the trade goes against you. That is true regardless of which stop loss you decide to follow. I don't just follow a straight 25%. Sometimes, I will sell at 12% or sometimes 35%. The bottom line is all my trades should have an exit expectation and plan. I am still perfecting this. For example, I don't like to jump into far advanced up-trends but because my portfolio is heavily slanted towards commodity speculations, I will sometimes make a "trade". I bought GRUB because everyone talks about how great it is. It has done quite well over the last year but I joined the party late. Suddenly it was up 23-24% in a day! Now that is unusual. I could find no reason but suspected it had to do with an earnings or anticipated earnings report. Either way, I was up 25% in about 1 month. I could find no reason to think that would continue without a significant correction in the future so I sold it. It was a small part of my portfolio, maybe 1-2%. I still think it was the right call on that stock on that day. My point is that tremendous increase in a month, satisfied my exit expectation. I had not written in down but have an unsaid rule to consider selling anything up that much in a very short period of time.

"In summary, your thoughts and recommendations are spot on for investors and force each of us to consider we may be wrong or if we are right, when will we take some profit?" – Paid-up subscriber Mitchell F.

"Hi Porter, as a huge golf fan from the UK I think you've made a great choice in sponsoring Kevin Kisner. His performance in The Open Championship was outstanding, he seemed to hole every putt for the first three days and his touch just deserted him a little in the final round. He'll be on the major winners' roster for sure in the not too distant future. But please, please ask him to smile a little... just occasionally!" – Paid-up subscriber Martin P.

Regards,

Justin Brill
Baltimore, Maryland
July 30, 2018