By Steve Sosnick,Chief Strategist at Interactive Brokers
This week started off with the S&P 500 Index (SPX) trading 10% below its recent highs. That is the textbook definition of a market correction. Corrections usually feel scary and awful when we’re in the midst of them – and this is no exception.
Yet this correction feels worse in many ways. The unusual nature of the recent rally is certainly a contributing factor to that sentiment.
We avoided a major correction in 2021, with a 5% drawdown serving as the maximum during a stellar year for most risk assets. We nearly had one in September 2020, with SPX falling over 9%. At that point we had rallied nearly 50% from the March 2020 low.
The March 2020 selloff qualifies as a bear market — the index gave back about 1/3 of its value — but it was a remarkably short rout, lasting just over a month. The Federal Reserve’s massive liquidity injections saw to that.
Broad Selloff
Interestingly, the highs of last December from which we are currently correcting were about 50% above the lows of September 2020. It appears that there is a subtle calculus among investors that a gain of that magnitude is hard to extend.
Corrections are typically broad based selloffs, and this is no exception. The problem is that many of the most popular stocks and assets among investors – particularly new investors – are suffering far more than the blue-chips that comprise SPX.
Cryptocurrencies and meme stocks have been especially hard-hit. For example, bitcoin is down over 50% from its November high and other cryptos have fared even worse. AMC has given back nearly 2/3 of its value in that time span, and about 80% of the value it reached at its June peak. The drops are similar in GameStop (GME), though its peak was almost exactly one year ago.
Capital Flows
Normally I wouldn’t give much thought to troubles affecting speculative pockets of the markets. The most highly speculative assets are usually somewhat of a sideshow when compared to the goings-on of major indices.
But this has been an extraordinary year-plus. We saw a massive influx of new investors into the market, propelled by a unique combination of stimulus checks and boredom.
While much of this new money was invested in well-known, time-tested stocks, a sizable portion of investors became enamored with speculation rather than investment. It was quite understandable.
Many of the new investors are young, and younger investors can often tolerate higher risk than their older counterparts. Some of that is youthful exuberance, some is the demographic fact that younger investors have more years to recover from investment mistakes than older ones.
Herd Mentality
Thus who could blame investors of all stripes from jumping on the bandwagon of rising markets? The Fed was busily adding money to the financial system, while the repeated bouts of fiscal stimulus, along with child care credits and student loan moratoria, allowed many investors to increase their net savings.
As real rates ranged from zero to negative, investors were quite rational to invest in equities rather than squirrel their savings into safer investments that paid nearly nothing. As their investments appreciated, their risk tolerance increased.
Many discovered that margin leverage could be an inexpensive way to boost returns and that options speculation can offer inherent leverage. Margin borrowing reached record highs as the cost of borrowing declined. This was a positive feedback loop – a highly positive one for those riding their winners.
Leverage & Risk
There is an unfortunate downside to leverage and risk. Taking more risk and employing leverage are wonderful when things are going your way. They are awful when things aren’t. And now, for many, things are going poorly. As of 2 weeks ago, nearly 40% of stocks in the NASDAQ Composite Index (COMP) were down over 50% from their highs, and that number has only increased as stocks have fallen.
As nasty as the decline might seem when we look at broad indices, the large stocks that dominate these market-capitalization indices are outperforming their smaller-cap brethren.
For example, the small-cap Russell 2000 Index is down over 25% from its November high. That’s a real bear market for those investors. The Russell 2000 failed to confirm SPX’s December high, and has been paying the price ever since.
Circling back to why the underperformance of speculative darlings should be a major source of concern, I have become quite concerned that those same new investors who have become key actors in the markets’ rise could now sour on investing entirely.
Fed Policy
It would imply that we see outflows from those investors just as fiscal stimulus seems dead and the Fed is discussing how quickly to raise rates and potentially remove liquidity from the system.
As concerning as those prospects are, another one concerns me more. It would be a real shame if we, as an industry, enabled a new investor class, offered them the ability to profit in unprecedented ways, only to make them feel like the game was rigged against them.
All successful investors have experienced losses in their careers, but this was a generational opportunity for both profit and loss in a very short time frame.
This post first appeared on January 24 on the Traders’ Insight blog.
Photo Credit: zooey via Flickr Creative Commons
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The Standard and Poor’s 500, or simply the S&P 500, is a stock market index tracking the performance of 500 large companies listed on stock exchanges in the United States.The Russell 2000 Index is a small-cap stock market index that makes up the smallest 2,000 stocks in the Russell 3000 Index.The Nasdaq Composite is a stock market index that includes almost all stocks listed on the Nasdaq stock exchange. Investors can’t invest directly in indexes.
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