Major market corrections are usually triggered by financial engineering rather than concerns about valuation or the economy. For example, the drop in late 2018 was caused in large part by the unwinding of the "short volatility" trade, the bear market of 2008-09 was due in large part to the sub-prime lending bubble, and the crash in 1987 was partially a product of something called "portfolio insurance."
Typically, there are other issues that help to accelerate the corrective action but it is extreme leverage or excessive speculation that tends to be the trigger for the sharp drops.
Last week's selloff provides another example of how financial engineering leads to a major market drop. SoftBank Group of Japan (SFTBF) has recently bought $50 billion in options tied to key big-cap technology names. This option transaction created something called a "Gamma Squeeze."
When call options are sold, the sellers will hedge the position by buying the underlying stock. This drives the prices up, makes the options more valuable and creates a positive feedback loop. In retrospect, it is pretty clear that this transaction is what helped to create the very strong momentum in the Nasdaq 100 and the individual "FATMAAN" names.
The market became aware of this trade last week and that triggered some unwinding. The Nasdaq 100 is now leading to the downside and is causing great market disruption as these big cap leadership names finally start to correct and valuation becomes an issue.
The corrective action of the Nasdaq 100 ( (QQQ) ETF) is not unhealthy but the big issue is whether it will lead to rotational action or drive cash to the sidelines. So far there is some strong rotational action occurring. Even though all the FATMAAN names are indicated lower Tuesday morning, the small-cap indices ( (IWM) ETF) are exhibiting some relative strength.
When the stocks that have lead the market higher for so long are correcting it creates negative sentiment but a deeper look makes it clear that there are many stocks that have not become overly overvalued or technically extended. The question now is to what extent will capital rotate into these stocks.
This will be a particularly interesting market for stock-pickers. The focus will be on the big picture and macro concerns but under the surface, there should be an increase in opportunities. That doesn't mean that stocks won't go lower in the near term, however, we need to be ready to move aggressively as opportunities and charts develop.
