By Tim Courtney, Chief Investment Officer
The market's taken us on a wild ride lately, deviating from the calm we'd grown accustomed to over the past 18 months. Late July and early August reminded investors that market risk still exists, with the CBOE Volatility Index (VIX) spiking from 12% to nearly 40% in a matter of days.1 As investors, it’s important to understand that corrections are necessary from time to time to maintain healthy markets.
While our recent market behavior didn’t quite meet the technical definition of a correction (10% drop), it came close and is a good example of how fast prices can change direction. As stock prices began falling and volatility rose, many news stories pointed to a disappointing jobs report as the root cause of the market commotion.2 However, that report was almost certainly not the cause of the near-correction; the market had been falling for weeks prior to the report, and actually bottomed the day the report was released.1 The report was only a part of a larger trend of weakening data points going back months, and smaller, value stocks that are more exposed to the risk of a faltering economy, performed better than the S&P 500 over this several week period.
Market prices do react to new information like the data in that report, but pinpointing how market corrections start is sometimes difficult or impossible. Many times corrections start innocuously as traders test prices and discover just how strong price supports are. We could use an analogy by comparing the market to a large building that is always being constructed and modified. Certain parts of the building have foundations and stable supports (e.g., fundamentals like cash flows and profits), while other parts are surrounded by scaffolding and temporary supports (e.g., investor sentiment or speculation). When the temporary supports are tested, they may give way and fail, at least until new supports can be constructed.
During our recent near correction, the area of the market that took the bulk of the price declines was the mega-cap tech sector. This is an interesting part of the market because it has both foundational support through strong existing cash flows/profits and temporary supports through speculation for the future success of AI, which so far has delivered very little.3 Some of the temporary AI speculation supports ended up getting washed away in July and August. What started this price testing is unclear, but it wasn’t the jobs report.
At about the same time, halfway across the world in Japan, the central bank there raised rates. In this case the unexpected rate hike, while very small, was the direct cause of price correction and the unwinding of long-popular strategies like borrowing in yen to invest in dollars. The move led to a drastic reaction—a drop of 12% one day, followed by a rebound of 10% the next.4
The market becomes more prone to correction when it moves in one direction too long without testing and becomes unbalanced. Corrections are healthy and necessary for markets to properly function. And, if there is no foundational support for prices to maintain at a set level, they probably won’t stay there. Reach out to your Exencial advisor with any questions.
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S&P 500® Index (S&P 500®) is widely regarded as the best single gauge of large-cap U.S. equities. The index includes 500 leading companies and covers approximately 80% of available market capitalization.
CBOE Volatility Index (VIX) is an index that represents the market’s expectations for the relative strength of near-term price changes of the S&P 500® Index (SPX). Because it is derived from the prices of the SPX index, an index tracking the S&P 500® options with near-term expiration dates, it generates a 30-day forward projection of volatility.
Invesco S&P 500® Equal Weight ETF (RSP) is an ETF based on the S&P 500® Equal Weight Index. The Fund will invest at least 90% of its total assets in securities that comprise the Index. The index equally weights the stocks in the S&P 500® Index, resulting in an exposure that tilts toward smaller companies in the S&P 500® Index which reduces the concentration risk relative to market cap indexes like the S&P 500®.