Big Surprises Make Investors Reposition Their Portfolios

Recent economic data and policy changes caused investors to doubt the durability of economic growth and reposition their portfolios. Stock indexes tumbled while bonds rose in late July and early August.

One trigger was the Employment Situation reports for July. The unemployment rate rose. The number of new jobs created was well below both expectations and the average over the last 12 months.

Disappointing earnings reports from several of the dominant technology companies didn’t help. Neither did surveys of manufacturers, which for more than a year showed the sector contracting.

But the main trigger for the plunge was the decision by Japan’s policymakers finally to support the yen against other currencies.

A number of investors had borrowed the weak yen at low interest rates and invested the proceeds in other assets, especially stocks. After the Bank of Japan’s policy change, many of the trades quickly were reversed, causing market turmoil.

The key factor in investing isn’t anticipating what will happen in the economy. The key is assessing the expectations that are priced into the markets and determining how they might be wrong.

Markets were priced for continued strong earnings growth among a few large growth companies, multiple interest rate cuts from the Federal Reserve and a steady decline in inflation without a reduction in economic growth. Investors also expected the Bank of Japan to continue to be complacent about the yen.

Investors suddenly realized some of their expectations weren’t realistic and began to readjust their expectations and portfolios.

I suspect investors also are realizing their portfolios are too concentrated.

Investors in index funds aren’t diversified. You’ve probably seen the data showing the technology sector’s share of the S&P 500 has been around the record high as has the share of the index allocated to its 10 largest positions.

Concentration in these assets has worked well in recent years. But concentration is a risky long-term investment strategy. History shows that the top-performing sector and asset class of one 10-year period usually underperforms in the following 10 years.

The good news is, while growth is slowing, the data don’t indicate a recession is imminent. The rise in the unemployment rate wasn’t due to significant layoffs. It was due mainly to labor force growth, primarily because of immigration.

The labor market is not as tight as it was in the last few years. The number of job openings is high but much lower than recent peaks. Wages still are rising faster than over the last two decades but not as fast as they did in 2022 and 2023.

Another downward pressure on stocks is that it appears the artificial intelligence revolution won’t progress as fast as many investors expected, though it still will be important.

There are problem areas in the economy, but they appear to be isolated and don’t seem likely to spread and cause a recession.

For now, economic growth looks sustainable, but at a lower rate than markets expected. Inflation and interest rates are stickier than the markets anticipated.

Investors haven’t done much rebalancing in the last few years, and that resulted in concentrated portfolios. The concentration makes investors dependent on falling inflation and interest rates, strong economic growth in the United States and high earnings growth in a few companies.

It’s a good idea for investors to reduce that concentration and adopt more balanced, diversified positions. Portfolios should be diversified geographically and across asset classes.