Everything You Need to Know About the Recent September 2020 Market Correction
We all knew the latest stock rally wasn’t going to last forever.
What took investors by surprise was the abrupt tumble in technology and momentum stocks. Most of the names that led the Nasdaq to a series of new highs through July to early September were the same ones that pushed it into a tailspin, marking its largest two-day drop in 30 years.
At the same time, the S&P 500 cut 6.7% from its September 2 record, the S&P/TSX is down 3.1% and the MSCI World Index 4.9%. The Nasdaq lost more than10% from its high. (Figure 1)
Whenever we see pullbacks like this, one of the most commonly asked questions is Why? While this might be the first thing on your mind, we believe it’s more important to focus on understanding complex issues such as Why is this price correction important? What does our reaction to this event reveal about our biases? How can we better allocate our portfolios to manage and protect capital?
Let’s start with your original question and figure out what triggered this correction. The financial press reported options-related trading—particularly those exposed to U.S. technology companies—is to blame. For those of you who haven’t used stock options, they’re hedging contracts that allow investors to buy or sell shares at a specific price
later in time. It gives the investor leveraged exposure to share price movements for a fraction of the cost of buying the shares directly. In a typical trading day, option flows
and related hedging are part of many activities and don’t tend to drive stock prices.
But in this instance, retail investors and institutions, including Japan’s SoftBank Group, were buying call options on tech stocks, which helped to propel the Nasdaq (already
buoyed by COVID-19 demand for technology), pushing it to records highs. Robust buying led to a psychological fear of missing out, so more investors jumped onto the hedging
train. This exacerbated both the rally and the sell-off.
It also highlights a bigger issue: the difference between gambling and investing. Gamblers might count their winnings at the top of the night and then lament losing everything in the morning after the house raked back their stakes plus their initial capital. An investor has a different mindset.
Now, I’m sure if you parse through the trades, some investors probably booked a profit in the last few days as well. And why not? If you’re in for the long haul and you’ve made ample over the last decade, why not lock in some gains at a high point. After all, the Nasdaq was up
83% from March lows and 21% over the 200-day moving average.
Taking money off the table doesn’t necessarily indicate a negative view on an existing position. A long-term investor adapts their outlook when the original investment thesis or the underlying fundamentals change. Have the underlying fundamentals or the secular story changed dramatically in the past couple of weeks? No. Tech stocks remain strong growth generators and the process of digitalization has only intensified, amplifying the impact on these businesses.
Why is this Correction Important?
Speculators—those betting on short-term movements— believe the recent correction was long overdue and expect more downside or at least volatility in the next several weeks as option positions unwind. For investors, however, this is a blip. A non-event. We aren’t speculating. We’re investing.
So why is this correction important? It provides us with an opportunity to stop and re-evaluate our investments, to question our biases and to keep an eye on proper portfolio
This is Not 2000
But let’s get back to FOMO, or this fear of missing out. It was one of the drivers behind the tech bubble of 2000. Even retired school teachers became indiscriminate buyers on the way up and then frantic sellers on the way down. And while we may have seen a little of that recently, the tech sector is a different beast to what it was two decades ago.
As highlighted in August Perspectives Anti-Grav Technology, many technology companies have outperformed over the past decade and have shot past broader markets this year with fundamentals intact. As Vitali Mossounov, Global Technology Analyst at TD Asset Management pointed out, we have been through one of the greatest financial crises in modern history which has severely damaged the vast majority of corporations.
In that time, earnings revisions for technology companies slipped 3.9% while industrials were slashed 54.3%. (Figure 3) Mossounov used the word “staggering” to describe the gulf that opened up between the S&P 500 and the Nasdaq over the past five years and there are reasons for this. While it could be argued that a lot of good news is already priced into tech valuations, these companies are no longer the zero-earnings flip-phone propositions of 20
or 25 years ago (which at the peak of the bubble traded at more than double today's forward price-earnings level of 28x).