As large and as abrupt as Thursday’s U.S. stock market selloff may seem to many, it should come as no big surprise to experienced investors.
Markets were poised for a pullback after five consecutive monthly gains; the best August in decades; successive records for the S&P 500 and Nasdaq indexes; and a two-day tear to start September.
A much more interesting question is what happens next. Will stocks get in line with a growing set of market segments that have been somewhat more attuned to fundamentals recently, or will this selloff simply trigger what has been an extremely reliable and lucrative “buy-the-dip” conditioning?
Consider what happened to the Nasdaq, the U.S. index that suffered more damage on Thursday compared with the Dow Jones Industrial Average and the S&P 500. Its noteworthy 5% selloff took it back essentially to the level of just seven trading sessions ago. It made little dent in what is still an impressive 28% year-to-date gain, let alone the remarkable 67% surge since its March 23 low. And some of the index’s single listings offer an even starker contrast: Tesla’s 18% selloff over the past three days pales in comparison to its year-to-date gain of 386%.
This selloff in markets is also not that remarkable when compared with what has been happening in other market segments. The recent stock records contrast with the more cautious, if not contradictory, traditional signals sent by declining government debt yields, steady high-yield risk spreads and a rising VIX.
Finally, there is the stock market’s significant disconnect with realities on the ground for the economy and many companies. While growth and employment have recovered, the pace of improvement has moderated and hopeful expectations for a V-shaped recovery have increasingly given way to both less upbeat short-term projections and greater concerns about longer-term damage to the vitality of supply and demand.
Rather than being surprised by what happened on Thursday, the focus should be on what happens next — a question whose answer has been rendered a lot more uncertain by the extent to which extremely loose monetary policy has distorted market valuations and conditioning. Specifically, two sets of forces are facing off: the continuation of favorable market technicals versus the positioning of the derivatives market and the greater assertion of fundamentals.
Years of ample and reliable liquidity injections by central banks and their strong signaling of continued and exceptionally loose monetary policy have conditioned investors to buy on the dip. After all, what is more assuring than central banks’ large-scale asset-purchase programs? The purchases of securities, which now extend for the Federal Reserve to more default-sensitive high-yield bonds, are made by entities that are not sensitive to price levels and have printing presses that seem to face no constraints, at least in the short-term. It’s an operating paradigm that has been increasingly embraced by retail investors whose access to markets has been facilitated by a proliferation of fractional ownership programs and more millennial-friendly investment apps such as Robinhood.
This conditioning is also influenced by the positioning in the derivatives markets. On the one hand, it has discouraged outright shorting of stocks by those concerned about valuations. After all, such positioning has been consistently steamrolled by the favorable technicals. But it also led to more call buying, rather than outright purchasing with cash, and tail hedging. This suggests that a meaningful initial decline in stocks, should it materialize, would more likely lead to more professional selling than immediate buying. Such selling would accelerate if what has been a mindset strongly dominated by liquidity — stocks and other risk assets are cheap relative to government bonds — gives way to one that is more focused on fundamentals — that is, at prevailing stock valuations and overall high-yield bond yields, investors are not being rewarded enough to underwrite the risks associated with continued pressure on corporate revenues and higher chances of default.
Where investors end up in this tug-of-war will depend largely on their investing DNA — do fundamentals influence their behavior, or have years of liquidity conditioning obliterated what was once almost canonized for them? My own inclination is that fundamentals tend to ultimately assert themselves. If that doesn’t happen now because of residual central bank conditioning, it will be in one of the subsequent records and involve an even larger downturn. The hope for investors is that fundamentals improve enough in the months ahead to make the eventual reconciliation with technicals less painful.
Mohamed A. El-Erian is a Bloomberg Opinion columnist. He is the chief economic adviser at Allianz SE, the parent company of Pimco, where he served as CEO and co-CIO. He is president-elect of Queens' College, Cambridge, senior adviser at Gramercy and professor of practice at Wharton. His books include 'The Only Game in Town' and 'When Markets Collide.'
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