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Are stocks heading for a further correction?

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By Hussein Sayed, Chief Market Strategist at FXTM

Equity markets are showing some signs of stabilisation following two brutal days late last week which dragged the S&P 500 and the tech-heavy Nasdaq 100 down by 4.3% and 6.4%, respectively.

There was no specific trigger to the selloff but after extreme bullishness driven by monetary and fiscal policies, stock prices reached levels that could no longer be justified by fundamentals.

There is no doubt that the investment environment has drastically changed compared to a few years ago.

Given the new approach of the Federal Reserve towards ‘average inflation targeting’, investors are not concerned about tightening monetary policy, at least for the next couple of years. Theoretically, this means businesses will enjoy cheap debt financing in order to expand, leading to higher potential future earnings.

It’s true that valuing a company at a lower required rate of return provides a higher intrinsic value for the stock price, but what we have seen over the past several weeks was more euphoric and about momentum buying rather than rational investment.

Fears of missing out on the rally also led many investors to jump into the market without doing proper analysis. While we still cannot compare the current environment to that of 1999-2000, investors need to be concerned about the price they pay to acquire stocks.

The steep correction seen on Thursday and Friday is healthy and much needed after the five-month rally, but it requires a more extended pullback to encourage long term investors to build positions.

We probably need another 10-15% drop to end this euphoria and this will only happen if investors put more focus on current fundamentals that have been ignored for several months.  Let us not forget that we have not yet found a cure for the coronavirus and corporate bankruptcies will be on the rise as we approach year-end.

Liquidity and low interest rates alone cannot be the solution to everything, so it’s essential to see continued improvement in economic data and an end to the pandemic for sustainable upside in risk assets.

 

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