The Shot Across the Bow

Well, this was different. The runaway Tech rally with reckless abandon ran out of gas. It was only a matter of time. You never know when, nor do you know why; it just does when it does. I’d like to say that there was some clear catalyst. There wasn’t. Speculation got overexcited. There is some evidence that a segment of the speculation got neutralized this week. A semblance of reality has returned. That is good for everyone.

Stubbornly strong: That’s how I’ve described the Stock Market in recent weeks. Maniacal is another. This relentless rally became quite ridiculous. When you have large cap company stocks up anywhere from 30-50% in a day, there is something not right. The value of the business could not have changed that drastically within a 24-hour period on no news. One theory buzzing around of late was that there was an explosion in demand for Call Options betting big on Tech. That fueled the gains in stocks as Market Makers were forced to hedge. That kept the momentum going and the price action one-directional. That explanation seemed very plausible to a Stock Market that became nonsensical. It turns out it was true. It’s being reported that SoftBank, the large Japanese investment institution, bought Options tied to around $50 Billion worth of individual Tech stocks over the Summer. The strategy ran into a wall on Thursday. It continued its unwinding today.

We are at that stage in the Market where we find there’s a lot of “this has never happened before” or “the last time this occurred was during the Dot-com days.” The result has been a handful of stocks moving the indexes around, but it really speaks to how weak everything else has been. It has been crystal clear that a major divide widened between the Stock Market and the Economy. We understand that the Stock Market is not the Economy and the Economy is not the Stock Market. But they do have a relationship. Some days they’re best friends. Other days they’re more like distant cousins. Make no mistake, the Stock Market and the Economy have a storied relationship.

Back to this Call Option story, because it’s an interesting one which is quite telling. Well interesting for we Market geeks, but there’s something in here for all. Stay with me here. I mentioned the surge in demand for Call Options on Big Tech. It was reportedly centered on Amazon, Apple, Netflix, Tesla and Salesforce, which exacerbated the already big gains in the stocks as the dealers further hedged. In August, there were 22 Million more Call contracts than Puts. That broke the previous record set just in June. At one point, Option trading accounted for 12% of NYSE volume. That is absolutely unheard of. Remember the term “Maniacal” up above referring to the Stock Market this Summer. This helps explain it. Also, in case you’re wondering, buying a Call is a Bullish bet. Buying a Put is Bearish.

The Option frenzy spread into the broader Market rally with forced buying in the NASDAQ 100 and S&P 500 futures to hedge relatively illiquid single-stock options positions. From a fundamental perspective, the Tech rally has been justified with an insatiable demand for secular growth and disruption themes. Big Tech also has outsized leverage to the central bank liquidity tailwind. Those points are true. But the level of extremes seen this Summer brought reminders of only one other period in Stock Market history. You already know: The Dot-com Bubble in Y2K.

In the Options Market, the 5-day equity Put/Call ratio dropped to just 0.406. That was the lowest level in nearly 20 years. The lack of investor interest in Put Options reflects extreme confidence, if not overconfidence, that the Fed is the backstop. The closest the Put/Call ratio has come to this level in the past decade was in April, 2010. A 16% correction followed. Extreme Bullishness can and often does coincide with disjointed internals. When put together, it usually spells trouble. It’s a sign that the speculation is taking place on a weak foundation. That seems to fit the bill today, with such a challenged Economy.

It was not just SoftBank. This fever-pitched Option activity and precipitous decline in the Put/Call ratio began with the stay-at-home orders in March. It was when sports were shut down; March Madness, the NBA and the MLB delay. It seems quite possible, if not probable, that the new Day-traders emerged in a big way. The Stock Market became their sportsbook. With free trading at the ease of an app on their phones, bets were made with expectations of big payouts. The Options Market was open for business while so much else was closed.

With sports slowly reopening, the Put/Call ratio seems to be slowing its descent. It’s normalizing. It actually jumped on Thursday with the Market decline. If a return to sports causes a slow disengagement from the Stock Market, particularly from those buying Call Options, there could be a lot of momentum traders leaving the Market. The much anticipated NFL season begins next week. This does not seem altogether coincidental.

I have been asked on numerous occasions since the Dot-com bubble burst in the year 2000, two decades ago, how will I know when another bubble is here. It’s a hard question to answer. It’s an important question to study. Asset bubbles are human creations. The challenge in identifying them is you can be absolutely right, but very early. Keep in mind, Fed Chairman Alan Greenspan made his infamous “Irrational Exuberance” speech in December of 1996. That was 3 1/2 years before the Dot-com bubble burst, which was in the Spring of 2000.

We definitely saw a bubble in housing in the early 2000s, which ended up triggering the Financial Crisis. There was a bubble in commodity prices too in the mid-2000s. I think we officially reached bubble territory for the Stock Market this Summer, with a strong emphasis on Tech. The human element has been a driving factor in investing since its beginning. Even as technology has evolved and automation has played an increasing role in the Market, the human element still matters. The simple truth is, as prices rise, people tend to get more Bullish. The reverse is true too: As prices go down, people tend to get more Bearish. That’s the contrarian view. That has certainly been the case this year, in the crash down in February-March and the crash up ever since. Because fear is such a stronger sensation than greed, sell-offs tend to be quick and violent. Bull Markets can last far longer because making money can often mask underlying problems. Investor Sentiment tracked this week reached 61% Bulls and just 16.2% Bears. That is the widest spread since the January 2018 peak, which led to a 10% correction into February. Excessive Bullishness is a contrarian indicator that is never a reliable timing mechanism. It’s more of a warning light for the inevitable. There’s a funny term that is often circulated in the industry: “Don’t confuse a Bull Market with brains.”

The Tech-heavy NAS took it the hardest on Thursday, declining 5%, and leading lower again Friday. At one point, it was the worst 2-day stretch since March. After one of the most extended periods for the Stock Market in history, rivaling the Dot-coms days, Tech has been the undeniable leader with certain stocks defying gravity in their unabated ascent higher day after day. It was running beyond hot. This Market, fueled by the excess-liquidity from the Fed, has been conditioned for Boom-Bust cycles for a couple of years now. Fundamentals have not supported the moves. Speculation with Options has contributed too. There are some artificial ingredients embedded. This go-around just seems like people got sucked into the Boom and completely forgot about the Bust. This is only 2 days in, as Wednesday saw fresh, all-time highs. The Tech-heavy NAS saw 13 consecutive new highs. But how extended are things? Well, the 50-Day Moving average for the NAS is 400 points lower. The 200-Day is 2,000 points. If those come into play as a reversion to the mean, it translates to 3.5% and 16% lower. Remember this.

Keep in mind, there is still plenty of investor support for Tech. Bulls keep highlighting leverage to secular growth and disruptive themes. These are companies that are innovating in the Digital Age, whose business models have been accelerated by the pandemic. Tech also has leverage to the broader central bank liquidity tailwind, which is expected to remain for a while longer. The fundamental backdrop is very sound for Silicon Valley companies. The big question is: how much people are willing to pay for it? Up until yesterday, speculators were willing to pay more than ever before. The Stock Market, led by Tech, is still light-years away from cheap.

Apple and Amazon are considered must-own stocks, in this environment and any environment. They’re like the Crown Jewels of Wall Street. Their stocks, like most Tech stocks, just got way ahead of themselves and overbought. The comparison to the Dot-com days is an obvious one. But as it applies to these 2 companies, I think of Pebble Beach in the late 1980s. A Japanese investor, and alleged golf fanatic, bought Pebble Beach for a whopping $850 Million. But the global recession hit asset prices hard. Japan was the dominant innovator in the 1980s on the back of the Sony Walkman fame and Toyota’s American market share claim. It didn’t last. The over-levered investor ended up selling the American treasure for a rumored $500 Million a couple of years later. Coveted assets always experience extremes.

As bad as this week might have seemed, it’s important to understand this new Bull Market was up a ginormous 60% in less than 6 months. The 2 previous best starts to a Bull Market ever (1982 and 2009) were not this strong. But they all had a correction around the half-year point. The S&P 500 fell 3.5% Thursday, the day after making a new all-time high. The S&P 500 had its best day in 2 months on Wednesday and its worst day in 2 months Thursday. This type of occurrence is rare. It happened back in March of this year, as well as in January of 2018, and October of 2014. This was the 3rd largest drop ever after a new high. September 1955 saw a 6.6% drop the day after a new high the Stock Market was down another 6% a month later. November of 1991 saw a decline of 3.9% after a new high and the Market was down an additional 3.2% a month later. This provides some perspective on what Thursday’s 3.5% decline could lead to.

There is still a great deal of value in the Stock Market today. Just because Tech is way over-stretched, it doesn’t mean that there will be damage across the board. Not everything got hit when the Bubble burst in 2000. Many S&P stocks actually did quite well. They tended to be the more boring types of stocks that had not exploded higher in strong demand during the euphoria. For instance, while the NASDAQ fell 80% and the S&P fell 50%, Coca-Cola held in quite well, with just a 16% decline. Berkshire Hathaway actually gained 37% from 2000 to 2003. Johnson & Johnson did even better, rallying over 60%, while the overall Stock Market sold off.

This is an important stretch for the Market. This week was a warning, akin to a shot across the bow. There is fresh selling amidst the weakest seasonal period of the year. We are still battling the effects of the pandemic. This, ahead of what is expected to be one of the most contested Presidential elections in history. It all brings great uncertainty. Overbought and expensive Tech stocks account for a large chunk of the Stock Market. Initial support for the S&P 500 resides around 3400, which is near the February highs. This level got tested and held on Friday. Below that is its 50-day Moving Average, just below 3300. That equates to roughly 27K for you Dow watchers. We don’t see alarm bells ringing for a deep sell-off in the broader Market at this point, because there are many value type stocks which have not participated in the rally as much, so shouldn’t have as far to fall. A healthy correction would reign in some of the excess, put in a stronger foundation under the market and give an opportunity to buy some quality stocks at lower prices. The aggressive Fed policy should also help keep a floor under stocks, unlike periods of the past. The Fed has made it very clear of its intentions to provide support to the financial system. We are proceeding with great caution.

Have a nice weekend. Enjoy Labor Day. It won’t likely be the same as in previous years. It’s 2020. How Americans behave and the results in the coming weeks will greatly influence the path forward.

Be healthy. Be safe. We’ll be back, dark and early on Tuesday.


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