Despite a late-month rally, both the S&P 500 and Nasdaq saw their five-month winning streaks snapped in August. The market suffered a broad but mild pullback, hurting even the best funds.
The only stock fund sector to post a gain was natural resources, while the previously white-hot science and technology sector retreated.
As the calendar turns to September and beyond, Wall Street will look for signals the Federal Reserve's rate-hike cycle to tame inflation is near an end. Investors will also be monitoring the economy for signs of recession or acceleration. In search of clues, they'll be watching to see if consumers keep spending and unemployment stays low.
Tough Month For Stocks In August For Best Funds
In August, small caps suffered the brunt of the selling. The Russell 2000 tumbled 5.2%. The Dow Jones Industrial Average fell 2.4%. Monthly declines in megacap tech stocks like Apple, Microsoft, Facebook parent Meta Platforms and Tesla dragged the Nasdaq and the S&P 500 down 2.2% and 1.8%, respectively.
Despite the summer swoon, major U.S. stock indexes remained firmly in positive territory at the end of August for the year. The Nasdaq was up 34.1%, the S&P 500 sported a 17.4% gain. The Russell 2000 and Dow were up 7.9% and 4.8%, respectively.
Summer Rally Hits A Wall
The summer rally in August ran into a wall of high valuations and lofty investor expectations that many companies couldn't meet. A continued rise in borrowing costs also sparked selling.
"What dented the rally in August was the jump higher in interest rates," said Chris Zaccarelli, chief investment officer at Independent Advisor Alliance.
Indeed, Fitch Ratings' downgrade of U.S. debt from AAA to AA on Aug. 1 set a negative tone. Investor fears that inflation will remain above the Fed's 2% target for longer and a growing belief that a recession in 2023 is unlikely pushed the yield on the 10-year Treasury to its highest levels since 2007 before retreating to 4.11% at month's end.
Even Best Funds Suffer
The across-the-board selling pushed the average U.S. diversified equity fund down 2.6%, according to Refinitiv Lipper data. Alternative energy sector funds, which invest in clean technology and renewable energy, got crushed, falling 10.3%. Most other sectors fell between 4% and 5.5%.
A blowout earnings report on Aug. 24 from market leader Nvidia, a leading player in the AI chip space, jump-started the late-August rally. It also propelled Nvidia to a nearly 21% gain from its August low. Nvidia's results reminded investors of AI's potential, providing a lift to science and technology funds, which trimmed their losses and finished August down 3.2%.
All the top-20 diversified stock ETFs finished August in the red. The 10 largest ETFs by assets under management, which include Invesco QQQ Trust and Vanguard S&P 500, also posted losses.
Many of August's biggest losers were funds and ETFs that rallied sharply in July. Ark Innovation ETF, which invests in disruptive innovation companies, for example, slid 13.3%, trimming its year-to-date gain to 40%. Renaissance IPO ETF declined 10.8%.
Investors Eye High Rates, Opportunities
The big ETF winner on the fixed income side was Simplify Interest Rate Hedge, a portfolio that hedges against rising rates, which jumped 7.6%. The leading stock ETFs were in the cannabis space. The top-performing sector ETF was Advisor Shares Pure Cannabis, which rallied 20.1%.
It's no secret that AI is leading the tech-stock surge like dot-com stocks did in the 1990s. But Zaccarelli says he wouldn't be surprised if the AI momentum continues despite rising valuations and the fact that its true potential is still years down the road.
"Investors always get excited and bubbles form," Zaccarelli said. As for Nvidia, if the company continues to surprise to the upside with its financial results, "the stock can keep running," he said.
What's Next For Best Funds
Top mutual fund managers are expressing caution. That's partly because they think the broad market is still expensive. It's also unclear whether the inflation genie is back in the bottle, especially with the economy still chugging along and U.S. crude at a 2023 high and nearing $87 a barrel. Economic uncertainty also remains high.
Nabil Hanano, associate portfolio manager of the Global Focused Growth equity strategy at T. Rowe Price, isn't betting on inflation falling to the Fed's 2% target anytime soon. Instead, he expects "higher inflation for longer." As a result, he doesn't see the Fed cutting rates in the near term.
Nor does Hanano see valuations rising further from here.
"So, I think you have to be more cautious going into the end of this year where we could have an inflation surprise," said Hanano.
Playing Defense
In this environment, Hanano advises investors to build a balanced portfolio. He says to include a mix of defensive stocks that have been underperforming and growth names that have been working better.
To ride out uncertainty in coming months, Hanano likes health care stocks such as insurer UnitedHealth Group and drugmaker Eli Lilly. And you need exposure to AI, too, despite higher valuations, he adds. His AI pick: Nvidia.
A potentially weakening economy is what worries Daniel Morris, manager of Manor Growth Fund (MNRGX), a 2023 IBD Best Mutual Funds award winner.
"I am concerned about the underlying economy," said Morris.
The bite of higher interest rates and cost of higher wages will weigh on companies' bottom line, Morris says. And consumers will have a tougher time spending as Covid-19 stimulus wears off and the student loan payment deferral ends.
Are Consumers Stretched?
Consumer credit card balances are on the rise, a signal that household budgets are becoming a little stretched, he says.
"As those things come to an end, I think that spending power is going to get hit on the side of the head," said Morris. "There's bound to be a slowdown at some point in time."
The result, he says, is companies will have to navigate through a more challenging economic environment. That's why he likes Apollo Group Management. It's an asset management firm that provides financing and restructuring services to companies. "There's going to be continued demand for that kind of thing," Morris said.
Morris is also bullish on Salesforce.com. The company's cloud-based software helps companies manage sales, marketing and other tasks. These types of services, which Salesforce is now enhancing with AI tools, will be in greater demand if the economy weakens, says Morris.
Watch Out For Momentum
Now might be the time for investors to focus less on hot stocks riding momentum and turn to value stocks that are selling at depressed valuations, says Michael Morey, co-manager at Integrity Dividend Harvest Fund (IDIVX).
The AI investment craze, he says, can't last forever. "At some point, you're going to have a correction," said Morey. And that includes AI juggernaut Nvidia.
The average stock presents better value than the megacaps that have led the market this year, says Morey.
"Where we see pockets of opportunity is within the value space," said Morey. "We've seen a great reset."
Best Funds Plug Into Utilities
Right now, he likes two hard-hit utility stocks, American Electric Power and NextEra Energy. Both stocks sport dividend yields that are higher than the market average. But they also offer growth potential and total return potential that you can't get in a high-yielding money market fund, says Morey.
Morey's investment philosophy is about investing in stable, income-producing companies that can weather any storm.
"What we really are trying to emphasize to investors is stay invested and ignore the noise," said Morey. "And an easy way to do that is to invest in a responsible manner, where you're focused on free cash flow, consistency, and companies that have the ability to grow at a very reasonable pace and allow you to sleep at night."
