A healthy correction? Or the start of the rout?
Last week, the US equity market which was way overdone and irrational witnessed a sharp correction, as declines in technology stocks continued after a five-month rally came to an abrupt halt. Besides worries that valuations had been pushed to unsustainable levels, perhaps many are also concerned about the looming risk of volatility, due to the upcoming Nov US elections.
The blow-up in short-dated stock call options is also a feedback loop on the downside, since market makers had to dump cash holdings as they adjusted their hedges. Evidence also shows that the smart money crowd was already seeking downside protection in their tech portfolios over the past week.
The market had been in need of a “healthy correction” to blow some of the froth off Big Tech and provide a fresh buying opportunity at more attractive prices. Still, elevated valuations require vindication in the form of robust earnings growth over the coming quarters.
The risk aversion mood saw USD having fresh haven inspired short-covering, rallying together with the safe havens of US Treasury and Yen, while Sterling Pound slid on the back of renewed fears of no-deal Brexit. Although the recent strong run-up of risk assets was partly aided by the sell-off of USD, moving forward, this tailwind may start becoming a headwind instead.
Given the market’s current hefty short-USD positioning, if the broad USD short-covering accelerates over the coming week, it could result in a broader impact of exacerbating deleveraging across risk assets such as commodities and equities.
Meanwhile, US-Sino tensions will remain elevated, and the bellicose rhetoric will likely escalate as we head into the US presidential election. With less than 60 days to the election, markets shall begin to price in the prospect of a Biden victory or the uncertainties that will be brought about if the electoral result is contested. What might have been a bearish start to September could very well turn into a sustained rout on risk assets.
However, while many continue to hold the belief that the Fed’s trillions of dollars liquidity injection through its mega monetary easing packages will continue to support the stock market rally, that it is only true when stock valuations fall back to reasonable levels. Furthermore, as the coronavirus pandemic remains virulent globally and evidence shows that economic recovery is stalling, while Tech still offers solid growth prospects and the potential for a significant return on equity, the balance of risk still lies with corporate earnings undershooting expectations, reminding the markets that sustainable levels of valuation still matter most.
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