The U.S. market shock in September was the accumulation of a series of investor worries centered on the performance of technology and growth stocks this year, and reverberated through global equity markets. A market, fuelled by central bank largesse, economic surprises and record earnings beats in the last few months, was never going to maintain its heady pace forever. Market tremors are a normal, albeit uneasy, part of investing and not all shocks are a warning of an impending collapse in risk sentiment.
The U.S. stock market dropped by 3.5% on September 3, representing the largest one day decline since June 11, and the market continued to slide in the following days. A correction is not surprising in a market that had increased by 53% since the low in March and recovered to its previous peak in a little over 170 days, marking one of the fastest turnarounds from a bear market back since 1968.
There was no single reason that triggered the market move, rather the turn in investor sentiment towards the frothier parts of the market reflected a buildup in nerves about the strong performance of a few technology-related companies, rising valuations and potential speculation from retail investors. The move may have been exacerbated by the unwinding of momentum trades and the use of derivatives in boosting tech stocks in recent weeks.
Where to from here? After the June sell-off, the S&P 500 recovered in a matter of weeks. While the September market drop may have eased some concerns surrounding overcrowded positioning in some sectors, a recovery may take longer to eventuate, given the pace of the rally experienced this year, lingering concerns around market concentration and key events in the months ahead, such as the U.S. Presidential election.
The narrowing in the polls between the two candidates, particularly in key swing states, is likely to keep investors on a more even keel into what will no doubt be a volatile period for markets. Furthermore, with the U.S. earnings season done for another quarter, the focus will shift from micro to macro and the direction of the economy. It is possible that economic momentum in the U.S. starts to wane in the coming months as the initial bounce out of recession fades and fiscal stimulus efforts remain constrained by partisan politics. This may limit the ability of economic data to surprise to the upside and boost equity markets. Finally, the starting point for a leg up in equities is less favorable now than in June, as aggregate equity short positions have been greatly reduced according to data from the Commodities Futures Trading Commission.
Markets may move sideways rather than upward in the coming months, given the near-term event risk, elevated valuations and concentration of returns in the U.S. equity market. Given the growth market share of the technology sector in the S&P 500 index over time, the strong run this year has helped to lift overall returns. Exhibit 1 shows the contribution of each sector to the total market return since the market low on March 23. Technology accounts for 17% points of the 53% return off of this year’s low; this is almost one-third of the market return and is almost equal to the contribution of the next three sectors combined. Naturally, any reversal in sentiment towards this sector would drag the overall index down.
Exhibit 1: United States: Sector contribution
There is clear investor unease about the impact of a few very large companies on the overall market performance, and elevated valuations when it comes to the U.S. equity market. Concentration risk along with elevated valuations is reason for caution, while the dispersion of returns and valuations between the top and the bottom performers in the U.S. equity market this year highlights the need for an active approach. The equity market could react to negative headlines from the U.S. election campaign and possible regulatory changes that may impact the technology and internet-related stocks.
Short-term concerns should not outweigh the longer-term potential offered by growth and technology stocks and the recent jitters are unlikely to lead to a repeat of the technology sector collapse in 1999. Today’s technology sector companies are more profitable overall and the future earnings potential in the coming years from areas, such as cloud computing and artificial intelligence, as well as the benefits that accrue to many of these companies, form the shift in corporate attitudes towards physical workplaces.
Investors typically dislike the uncertainty, particularly when it comes two key issues, namely a vaccine and the U.S. election, that can quickly change the direction of the market. However, easy monetary policy and fiscal stimulus will underpin the equity market as they influence the economic outlook. Governments’ willingness to continue to support household incomes and businesses until a vaccine is readily available or until the virus is brought under control by other means will be key to economic outlook and investor sentiment.