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).
Fundamentals for the Future
Mossounov says the large cap tech companies boast fundamentals for the future. This defrothing of 10% for the tech behemoths is a healthy development given their strong run in August. Any further decline can be viewed as an opportunity to start building a position. Tech companies tend to have asset-light balance sheets which gives them a significant advantage when it comes to generating returns on invested capital. They're unleveraged and hold net cash positions, making them largely immune to a credit crunch. Once these companies are able to garner respectable market share, they tend to form a strong networking effect as it becomes difficult for their customers to switch to another product/service provider. This leads to a more stable and constant stream of cash flow for these companies. Though this not true for every tech company, it does apply to the broader set. That’s why they became the market darlings in an environment when growth was uncertain, stretched balance sheets were a liability and economies moved to work remotely.
Figure 4 shows the tech sector held the strongest net debt/ EBITDA position coupled with the highest free cash flow margin. To a large extent this explains the record highs and year-to-date rally.
Tech in Every Aspect of Our Lives
Between the decades of 1990 and 2010, we’ve seen a slowdown in economic growth caused by excess capacities, a slowdown in global manufacturing, and changing demographics in developed countries. But underneath this, a sweeping shift was colouring every aspect of society. Even before COVID lockdowns and working from home, tech had infiltrated our lives and it’s only intensifying. From F-35 fighter jets to our wine fridges, tech has taken over. It has transcended historical boundaries bridging the gap between growth and defensive sectors to become a consumer staple with growth benefits. In this new era,
businesses and economies are evolving and competition and demand are changing. As a result, the way you think about investing needs to evolve too.
While technology is in almost everything we touch from rice cookers to solar heating and doorbells to sewage systems, most investors in Canada have very little exposure to it.
Information technology is less than 9.5% of the S&P/TSX composite index and most of that is dominated by one company, e-commerce software provider Shopify (61% of the sector). If this is the only tech in your portfolio, you could miss out on the digitalization of the global economy.
What do our Reactions Reveal?
Put down your phone or step away from your computer, which is where you are probably reading this, and think about the things you have done differently in the last four or
five months. Wouldn’t you like to invest in the way the world is evolving and in the companies steering those social and economic changes? With central banks driving interest rates to zero to kickstart growth and inflation, is it wise to avoid exposure to the one part of the economy that’s growing? Ironically, one of the reasons inflation is so low is because technology, and the impact of its subsequent advancements, is deflationary.
In fact, put technology aside for a moment; most investors in Canada have very little exposure to growth. Is that how you want your investments to remain?
Here in the Great White North we’re renowned for our investment conservatism and our pursuit of income. As a result we’re, on average, overexposed to low-yielding government bonds and interest-sensitive equities. Yet for the past decade, growth stocks have dominated the market and it’s hard to see this ending any time soon. (Figure 6)
Status Quo Bias
Why do we behave this way when there are other opportunities? Our driver, or lack thereof, is known as status quo bias: think conservatism marked by inaction. In other words, we’re more comfortable remaining with what we know or maintaining a decision we made in the past rather than embracing change. In research published in Status Quo Bias In Decision Making, William Samuelson
and Richard Zeckhauser found that classic models of decision making vastly under-predict the degree to which
we default to the status quo. Even though this research is older, it’s supported by recent research on behavioural
economics which indicates status quo bias is more likely when there is choice overload or high uncertainty.
The problem with our status quo default is that investing is environmentally sensitive. Many investors have a portfolio designed and managed for an environment that has changed beyond recognition. They need to begin to adapt. An inability to adapt could easily cost a decade of growth and income. This isn’t just about getting exposure to tech companies or growth stocks. In a world where central banks and governments are working together to promote and create growth by building infrastructure— much like the post war period—private real assets and infrastructure are going to be major beneficiaries. And yet, most individual investors have almost no exposure to this area as well.
What Can We Do?
To prosper in this and future environments dominated by slowing GDP and low yields, we believe every investor will need more than the traditional tools of finance. We believe investment success is predicated on the ability to adapt as the world unfolds. This belief is at the foundation of our investment philosophy, Risk Priority Management which combines behavioural analysis with current macroeconomic and fundamental security analysis and
cutting-edge risk factor research in order to manage risk and returns. It’s the reason that the concept of Adaptive Markets is central to what we do.
Change can be scary, but it’s crucial to understand. Look at this recovery we’ve experienced over the past four months—talk about change! So what’s the best way to start? First, don’t be a gambler. Don’t chase the rallies or the returns. Technology companies, growth ompanies, and real assts are time sensitive: they are investments meant to be held by investors. Watch for opportunities when speculators are selling at a loss. Volatile markets
shake opportunities out of weak, usually speculative, hands.
Make sure yours are ready for the catch