The US major equity indices were off over 5% today in largest daily fall since March. The question on everyone minds is whether we are heading back to the lows or if this is a chance to buy.
Why has the market sold off?
News agencies and market commentators will be quick to point to some news event that has caused this move. But these moves are caused as much – or even more so – by investor sentiment and positioning.
The market rally since March was against incredibly poor economic data as investors were already bearishly predisposed and cautiously positioned. This meant the market reacted to the positive developments of improving virus cases and reopening economies rather than longer-term risks such as sluggish economic recovery or the possibility of a virus second wave.
After a 44% rally by the S&P 500 from 23 March to 8 June, it is obvious the broader market is more positively positioned than a couple of months ago. But within this some investor groups are positioned extremely bullishly, betting on the market rally to continue, while others retain a fair amount of conservatism.
The bullish group includes quantitative/algorithm type funds, momentum strategies that chase markets, some hedge fund strategies and parts of the retail investor market – particularly the hordes of new investors who opened accounts over the last couple of months.
Fundamental type fund managers generally retain elevated cash. Although many of these funds have reluctantly bought equities in recent weeks to prevent underperforming the equity indices too much in this sharp rally. So this group holds excess cash, but less so than a few weeks ago.
The sell-off happened today because investor positioning reached some kind of inflection point. News of a possible second wave of infections in the US, and a lack of additional fuel from the US Fed, appears to have been enough to tip the market over. In our opinion, the bad news this week differs little from news over the last couple of weeks such as US riots. The difference is that investor positioning has become bullish enough to react to bad news again.
Where to from here?
In the coming days, the market will be primarily driven by the unwind of bullish positioning from the groups mentioned above. It is possible this was all done today, but more likely there is more to go as many of these strategies may begin shorting the equity market (betting it will continue to fall) as a decline continues. This is one of the reasons the sell-off in March was so aggressive.
Against this, we will likely see fundamental managers who still have elevated cash begin to buy. Although it is not clear to us at what market level this will be.
Over the next weeks and months, the market should be driven more by the fundamental news. If virus cases in the US continue to worsen, or second waves emerge in Europe, this could drive a continued decline. The economic data will also be a driver. The market will be trying to determine whether we have a fast recovery to pre Covid-19 levels or is this likely to be a drawn-out economic downturn. The upcoming US quarterly results and US Presidential election will also come in focus. And if you find yourself getting too bearish, remember we will eventually see supportive comments from central banks if the decline goes too far.
Investors may want to consider the opportunities in individual stocks where they have a robust view on fundamentals and valuation rather than making a large bet on the short-term market direction. Buying an airline because it is down 10% today would not be considered a prudent opportunity unless you have a good reason to believe that the business is fundamentally sound and offers at least reasonable long-term value.