Stocks succumb to profit-taking

CIO Alert published 3 September 2020, at 9:46PM UTC

What happened?

After reaching record highs on Wednesday, major equity indexes fell as investors rotated out of the tech sector. US and Eurozone economic data suggested the pace of recovery may be slowing. The S&P 500 closed 3.5% lower, while the tech-heavy Nasdaq dropped by 5%. The big six mega-cap FAAMNG stocks dropped between 3.8% and 8%. The Euro Stoxx 50 erased its gains late in the day and dropped 1%, and the FTSE 100 fell 1.5%. Ten-year US Treasury yields declined 1.5 basis points. Gold remained relatively resilient, dipping by 0.6%.

A number of factors contributed to the sell-off:

1. Economic data.

• Today's weekly US initial jobless claims dropped by 130,000 to 881,000 in the week ending 29 August. But the decline was the result of changes in the Labor Department’s seasonal adjustment process. On an unadjusted basis, initial claims rose by 7,591, suggesting that the labor market recovery may be losing steam ahead of tomorrow's payroll report. Adding to the negative tone, the ISM services PMI for August fell to 56.9 from 58.1 the previous month, indicating a slower pace of recovery in the service sector, which accounts for most of US GDP. In the Eurozone, the services PMI barely expanded in August with a print of 50.5.

2. Sector rotation.

• Tech, particularly in the US, has been a clear beneficiary of stay-at-home trends during the COVID-19 pandemic. News that the CDC has asked US state officials to prepare for the possibility of limited vaccine distributions to high-risk groups as soon as 1 November added to optimism on an earlier vaccine delivery. But this earlier availability could drive a faster economic recovery, which could then prompt a rotation away from tech into more cyclically exposed sectors, such as value. After rising 70.6% since the low, tech has become a crowded consensus trade. And without reading too much into a single company’s results, Ciena Corp., a leading provider of equipment used in broadband networks, gave revenue guidance 18% below consensus and said it is "seeing negative effects of the pandemic and greater economic uncertainty weigh on our near-term outlook."

3. Option-related selling.

• After the extended rally in tech stocks, demand for further upside exposure from both retail and institutional investors has increasingly shifted toward demand for call options, where the buyer’s risk is limited to the option premium paid. But, conversely, option dealers selling the call options to meet this increased demand face increased price exposure. Depending on their exposure, dealers may need to buy the underlying stocks when the market rises, but may need to sell when the market is falling, which can exacerbate the price movements on days like today.

In the background, the lack of progress on a further US fiscal stimulus bill may also be causing investor concern, particularly with Federal Reserve officials highlighting the need for additional fiscal measures to maintain the pace of the recovery.

What should investors do?

First and foremost, we recommend staying invested according to your investment plan.

We recommend staying invested according to your investment plan.

We view today’s sell-off as a bout of profit-taking after a strong run. The S&P 500 enjoyed its strongest August in 34 years, gaining 7%, and added a further 2.3% in the first two days of September, to reach a fresh record high. Stocks are still well supported by a combination of Fed liquidity, attractive equity risk premiums, and an ongoing recovery as economies reopen from the COVID-19-induced lockdowns. The S&P 500 is now broadly at our central scenario target, yet further upside could also be driven by a combination of: 1) positive medical developments such as a vaccine being widely available by end-2020; 2) a sizable US stimulus package being passed with a US election outcome that doesn't hurt growth; and 3) a further drop in real rates.

We recommend three specific actions:

1. Ease into markets.

Volatile markets can leave some investors stuck on the sidelines, waiting for greater clarity or cheaper equity prices. But rather than trying to time the market and potentially miss out on gains, we recommend an averaging-in approach by establishing a set schedule to commit capital to stocks within a 12-month time frame. In addition, we advocate a put-writing approach to defensively enter markets, for those investors who can implement options. The VIX Index rose to 30, meaning the yield on such options is elevated, and the strategy can offer the opportunity to buy into stocks at a cheaper price, i.e., "buying the dip." We also recommend making use of structured investments to add asymmetric exposure to stocks, e.g., with a degree of capital protection. More on this here.

2. Diversify for the next leg.

The mega-cap IT complex has driven an outsize portion of the year-to-date gains in the US equity market. But while we don't think tech is in a bubble, we do recommend that investors with excess exposure to the biggest US stocks consider rebalancing into areas accelerated by COVID-19, such as companies exposed to the 5G rollout, and sustainability-aligned companies set to profit from a "green recovery." We remain positive on stocks, and maintain our view that the relative laggards in the rebound from the March lows, such as select value, select cyclical stocks, and US mid-caps, could drive the bulk of the gains going forward.

3. Protect against the downside.

COVID-19 has brought upon unprecedented uncertainty to investors, and further volatility cannot be ruled out. Diversification across asset classes and regions is the best way to manage the risks in one's portfolio. But given the low starting yields on high-quality bonds, investors will also need to seek alternative ways of diversifying their portfolios. We like gold, which at USD 1,931/oz offers further upside potential, backed by lower-for-longer rates and a weaker US dollar. Investors can also seek to insulate their portfolios by including some exposure to hedge funds with a strong track record of downside risk management. More on this here.

Visit our website for more UBS CIO investment views.

Please visit ubs.com/cio-disclaimer #shareUBS