September US Stock Market Sell-Off Explained: Is The US Stock Market Heading Towards a Crash?
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September US Stock Market Sell-Off Explained: Is The US Stock Market Heading Towards a Crash?

Joel Koh
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The market can stay irrational longer than you can stay solvent.”

—John Maynard Keynes

john-maynard-keynes-photo
Source: Vision

In other words, what influential economist and successful investor John Maynard Keynes is saying is that you may be correct that a market or sector is overvalued but wrong on the timing when it comes to investing.

And, timing the market is a fool’s errand, as no one can truly know the stock market’s peak or trough.

In terms of timing, 2020 has been a crazy year for the US stock markets.

The combination of events like the oil shock and worsening of the COVID-19 crisis that broke out earlier this year, sent the S&P 500 index falling about 34 per cent from 19 February to 23 March 2020 (~5 weeks).

This COVID-19 crash and bear market did not last long as the recovery came fast and furious.

The S&P 500 then wen on a bull-run, taking about just six months to recover to its February peak this year. At the time of writing, the index is still higher than its year-to-date levels despite the sell-off in US stocks and losses that occurred last week.

Will the US stock prices fall further or continue their bull-run?

Let’s evaluate the case for both.

What Is the S&P 500 Index

Before we begin it is important for you to understand the Standard & Poor’s 500 Index (S&P 500 index) which includes 500 of the top US companies in leading industries.

what is S&P 500 index

The index is weighted by market capitalisation, which refers to a company’s total number of outstanding shares multiplied by its share price.

The S&P 500 index, which was created in 1957, is considered to be a decent proxy to the US stock market performance.

But, you will need to know that the S&P 500 is not an accurate reflection of the US economy.

Every since the stock market crash in February and March this year, the S&P 500 Information Technology sector has been driving the index’s recovery.

Together, Microsoft, Apple, Google, Amazon and Facebook, from large components of this sector account for about 21.6 per cent of the S&P 500.

S&P500 tech sector sell-off
Source: CNBC

On 3 September, 10 days of gains in the S&P 500 Information Technology sector ended in a huge dropoff on 3 September, dropping 5.8 per cent.

The index dropped 2.3 per cent for the week, the first time it ended in negative territory in six weeks.

This selloff occurred after another 1.4 million jobs were added in the US in August while unemployment fell to 8.4 per cent, the first time it had fallen below 10 per cent since the COVID-19 pandemic reached America.

Will this sell-off expand into something more? Let’s see what the bears have to say.

The Bearish Argument

Tech Stock Bubble?

Amid the COVID-19 pandemic, tech stocks have been thriving.

Titans like Microsoft and Apple, as tech-heavy consumer companies like Amazon,have been doing well.

This has pushed up the valuations of tech stocks; with Global technology companies trading at a price/forward earnings valuation of 26.5x, about 30 percent higher than the MSCI World Index.

Although investors who had jumped on the tech stock bandwagon have reaped handsome profits since the stock price rally, the NASDAQ Composite Index’s 5 per cent sell-off is proof that these gains are not secure.

NASDAQ New York City
Source: Giphy

This bull market that we are seeing right now is not supported by strong foundations, as the US economy is still struggling with the COVID-19 pandemic, an unemployment rate that just fell below 10 per cent only recently, and many sectors struggling to stay afloat.

The ongoing narrative that is unfolding, is that there is a divergence between tech companies and the rest.

If you take a look at the S&P 500 Equal Weight Index (EWI) which includes the same component companies as the capitalization-weighted S&P 500. However, each company in the S&P 500 EWI is allocated a fixed weight – or 0.2% of the index total which is maintained via quarterly rebalances.

Even though this index has recovered from its trough in March, It has not risen above its June peak and has been subsequent flat.

In addition, if you take a look at the Russell 2000 small-cap index which has quite a few ‘zombie constituent companies’ is currently still below its June peak on an equal-weighted basis.

FYI: Zombie companies are defined as struggling companies that generate enough cash to continue operations and service their debts. But, for these companies, paying off their debts is out of reach.

Second Stimulus Package is on Hold

Currently, the American Government is still at an impasse over the second stimulus package.

Wallet Stimulation
Source: Giphy

Despite the US stock market showing bits of resilience within the Information Technology sector, the core of the US economy revolves around consumption. Consumer spending contributes a whopping 70 per cent of the United States’ Gross Domestic Product (GDP).

With the stimulus package put on hold, this might jeopardise consumer spending and could have a run-on effect on US GDP.

Also, I would think that the US stock market is perhaps pricing in for the possibility of an additional stimulus package from Washington; as the Government cannot come to a consensus about the size of the package needed to aid the unemployed and companies adversely affected by COVID-19.

Now for the bulls.

The Bullish Argument

High Valuations ≠ Stock Market Crash

Although there is reason to be concerned about overvalued stocks potentially causing another stock market crash, there is more than meets the eye.

If you look at the Shiller price-to-earnings ratio (P/E) (ratio created by Professor Robert Shiller of Yale University to measure the market’s valuation) it appears stocks in the S&P 500 are overvalued. This ratio is arguably better than the plain old P/E ratio as it removes the fluctuations that arise from the variation of profit margins during business cycles. It is calculated using the annual earnings of all the S&P 500 companies over the past ten years.

The ratio currently stands at a high of 33. The only other times that this ratio has been over 30 for an extended period of time is:

  1. Right before the great recession,
  2. Just before the dot-com bubble burst,
  3. The end 2018 bitcoin crash which caused the S&P 500 index to drop 19.7 per cent from end September to Christmas.

As such, a Shiller P/E ratio higher than 30 is generally a bad omen.

But, the valuation of a company can be less relevant for highly disruptive companies with innovative products and services. High growth companies like Amazon, Shopify, Netflix and Square tend to ‘ignore’ the traditional fundamental multiples and continue soaring.

In general, high valuations is not a strong enough case for a stock market crash.

Tech Stocks Are Not as Frothy as During The Dot-Com Bubble

froth beer can
Source: James Neilson | Giphy

I would not deny that quite a few tech stocks have inflated valuations.

However, a lot of these companies have been boosted by the pandemic, with strong growth underlined by substantial improvements in their fundamentals.

For example, Microsoft has posted a 14 per cent growth in revenue and increased its net income by 38 per cent in Q2 2020.

microsoft-q2-2020
Source: Microsoft

Other companies like Zoom video have grown exponentially during the COVID-19 crisis; with its revenue growing about four times in addition to posting a fat profit.

This also benefitted Amazon as well as Zoom is a big Amazon Web Services (AWS) client, as they could not keep up with the explosion of Zoom use during the pandemic and had to engage AWS.

In comparison, during the dot-com bubble, investors were fixated on frothy growth and chose to ignore the bottom line. They poured their money into companies that performed well based on superficial metrics, even though their business models were fundamentally flawed.

The generous influx of investor cash, saw many tech companies burning money to drive growth. When the bubble burst, the growth slowed to a crawl and the profits did not appear.

Buy of the Dip Investors May Be Activated

The selloff of tech stocks that occurred last week might also trigger a significant number of investors who tend to ‘buy at the dip.’ These investors might have been waiting with cash on hand to add these exciting growth stocks to their portfolio,

Closing Thoughts

At the end of the day, no one can really tell you where the stock market will go.

But, this September stock market correction was long overdue after five straight months of consecutive gains, records for the S&P 500 and Nasdaq indexes being broken and the greatest August in decades.

One thing you can expect is volatility according to the Cboe Volatility index, (VIX): a real-time market index that calculates the statistical degree of variance in trading prices over a time frame which reflects the market’s expectation of volatility for the next month. Vix index

The next two months could be quite rocky in the leadup to the 3 November 2020 presidential elections as well as the negative seasonality of the late-August and early-September period.

However, there is the risk of a correction in stocks, especially in the tech sector after the months-long rally, no one knows what’s going to happen in the short term. The US economic recovery could slow down or it could accelerate, especially if a COVD-19 vaccine is approved faster than expected.

The best thing for investors to do is to stay invested and own high-quality stocks, especially those with economic moats, tremendous growth potential or provide reliable profits at a fair valuation.

Want to Find Out More About Stock Market Crashes?

Why not join in the discussion on our SeedlyCommunity!stock market crash seedly
Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. ​Readers should always do their own due diligence and consider their financial goals before investing in any stock.

About Joel Koh
History student turned writer at Seedly. Before you ask, not a teacher. My time as a history student has equipped me with the skills to evaluate the impact societal development has on financial and nonfinancial events.
You can contribute your thoughts like Joel Koh here.

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