Co-founder and CIO
18 September 2020
Technology stocks have largely driven the market’s recovery after March’s market crash. But, between 2 September and 11 September, barely a few weeks after markets reached new all-time highs, US technology stocks declined by 11.1%. With that, the tech sector dragged the S&P 500 and the NASDAQ down by 6.6% and 10% respectively.
Here, we’ll take a closer look at what could have caused the tech sector correction, and as always, we’ll look at how market activity fits into the larger picture of the global economy.
Unlike other recent market corrections that have occurred in response to global events, such as political turmoil, trade wars, and the pandemic, this latest correction was widely believed to have been caused by a large number of investors unwinding their call option positions on US technology stocks.
A call option is a contract that entitles the option buyer the right to buy a security at a predetermined strike price. In hopes of making a profit, the call option buyer essentially makes a bet that stock prices will go up by more than his option’s strike price by a specific date (the call option’s expiration date).
To illustrate, suppose a particular stock is $80 USD today, and an investor believes that the stock will go up to, say, $150 USD, in 30 days. The investor could buy a call option with a strike price of $100 USD for a fraction of the stock price (this is called a premium). As the strike price is $20 USD “out of the money” versus today’s price of $80, an investor would pay less in premiums to own this call option. If the $150 USD scenario plays out, the investor could close his position by taking profit on the difference (simplistically, that’s $150 USD - $100 USD = $50 USD).
Traditionally, the options markets weren’t very accessible to retail investors. But, today’s trading technology makes it easy for any investor to trade options. In the last few months, the bullish sentiments around the tech sector spurred retail investors and large institutional investors alike to buy up call options on that sector rampantly.
When options near their expiration dates, call option owners face increasing pressure to sell their options and take profit before expiry. When this happens at a large scale, stock prices can drop. This is what is believed to have caused the recent market correction.
Let’s put the tech sector correction into perspective: Prior to September’s correction, US technology gained 80.9%, and sub-sectors, such as disruptive innovations, and global video gaming and eSports, gained 152.9% and 82.6% respectively since March’s market crash. These sectors have only lost a fraction of their total gains in this correction.
As Figure 1 shows, the equity sectors lost between 1.1% and 14.4% of their total returns in September’s correction. In particular, disruptive innovations, and video gaming and eSports lost about 7.8% and 8.5% of their total gains respectively.
Source: StashAway, Bloomberg
Corrections are a way for the markets to flush out bad behaviour, such as overbuying particular securities, so we can consider the pullback in US technology stocks to be healthy. This latest correction is yet another example of how markets react unpredictably to any number of unexpected events. The reminder here is that it’s crucial to always be prepared to face the markets’ inevitable short-term unpredictability.
We always consider any market movements, including corrections, in the context of the broader economic environment. In this case, the recent tech sector correction occurred against the backdrop of an improving global economy.
Globally, economic data show improvements across different countries and regions, as shown in Figure 2. Since Q2 2020, the contraction in economic activities is gradually becoming less severe as the year wears on. Exceptionally, China is now showing positive growth. The Li Keqiang Index, our preferred leading economic indicator for China, shows a 7.27% YoY increase in economic growth.
Source: StashAway, Bloomberg
In addition, China’s domestic consumption (proxied by retail sales data) showed a 0.5% YoY increase in August, and the country’s industrial production expanded 5.6% YoY.
The signs of economic recovery are encouraging, to say the least. Yet, we have to keep in mind that, because we don’t yet have an effective COVID-19 vaccine, we could still endure economic uncertainty in the near term.
But the pandemic aside, the recent tech sector correction shows us that market corrections and volatility can occur when investors least expect it. So, it’s important not to get caught up in the short-term market enthusiasm when prices go up, and take on more risk than you’re comfortable with in the hopes of even better returns.
If the recent market correction made you feel uneasy, or at least, made you think twice about your portfolios’ risk, take time to check your risk levels again. When you’re confident that your portfolios and your emotions are prepared for any and every market-moving event, it’s much easier for you to continue to stay invested in the markets (and in your financial goals) for the long haul.