What causes sudden market declines like we saw this week, seemingly out of nowhere?
There often isn’t a concrete reason. It’s important to remember that stocks trade in a market like any other good: when there are more buyers than sellers, prices move higher; when buyers dry up, this can reverse quickly. It’s been argued that certain large cap growth stocks have become frothy in valuation—particularly in the technology sector—as investors have crowded into profitable segments that are ‘working’ despite mixed results in other segments of the market. Some adjustments by options hedgers were blamed at one time. Some are blaming day-trading follies by fickle retail investors, who presumably either have more time on their hands, or usually engage in sports betting as an outlet for speculating, but regardless, may not be as focused on fundamentals as are institutional investors. Or, perhaps the overall economic news has been just ‘too good, too soon,’ with Wall Street conditions looking very different from those on Main Street, the latter of which is still facing significant struggles which aren’t fading as quickly as hopes for ongoing government stimulus and a vaccine release remain high.
The S&P’s declines last week, on Thursday of -3.5%, followed by another -2.5% at one point on Friday (before recovering), were unexpected, but not overly surprising considering the strength of equities in recent weeks. September has the reputation of being one of the most volatile months of the year, with the added element of continued pandemic-related uncertainty. Ironically, this decline coincided with news that the CDC had ordered states to begin preparations for vaccine distribution as soon as November.
Another factor is recency bias—the phenomenon that we can become detached from normal market behavior during long stretches of low volatility. For the last five decades, the average daily move for the S&P has been +/- 0.7%, with a standard deviation of 0.8%. This implies that a daily price change of two standard deviations (or +/- 2.3%) has about a 4.6% probability of happening on any given day (so half of this, or about a 2.3% chance for a down day of that magnitude). Volatility has a tendency of clustering, as it has this year, while summer 2020 has been tame but steadily higher. Based on a variety of overall market metrics, despite concentration to the largest tech firms reaching high levels, broader indicators point to non-frothy valuations using earnings expectations for the coming few years—reflecting a post-Covid ‘normal’ environment. In ‘normal’ conditions, it’s reasonable for investors to continue to expect ‘normal’-like returns.