Vivek Radhakrishnan
Edited
🔎 The Market Correction And so, concluded a tough week across the equity markets with a retreat of ~4% on the $SPX500, $DJ30 and $NSDQ100 retreated roughly 5 and 7%. Before we go into the analysis, let me shed some light on a few key concepts and then we can take a look at what really happened. 🔘10-year treasury bond – This is a loan that you give to the government and is issued in the form of coupons with a fixed face value and interest rate. This instrument is pretty much the safest form of investing because the likelihood of the US government defaulting on a loan is extremely low. The coupons are bought and sold in the market. 💱 Yield – The yield of a 10-year treasury bond goes up if the value of a coupon goes below face value, that means that the returns you can get from buying a coupon goes up because you are buying it below face value and will be able to sell it at face value + gain the fixed interest. Vice-versa, when the value of a coupon goes upwards, the yield is lower because the expected returns is lower. Now let’s go into what’s changed in the market. ❓Why did the market retreat❓ The 10-year treasury yield started to show glimpses of recovery after a long period of decline. The yield went up from 1% at the beginning of the year to 1.5%, which means that the value of the coupons started to fall. An improved economic outlook, which usually ends up being a function of improved growth and a rise in inflation; this tends to lead to the fed increasing interest rates. This begs the next question, why should this prompt a stock market sell-off? As the outlook for improving economic growth settles in, the appetite for the 10-year treasury coupon tends to go down which reduces its value and hence tends to generate a higher yield. As the appetite for the treasury note goes down, the fed usually reacts by hiking up interest rates. Increasing interest rates makes the equity market relatively less attractive to an investor because instruments like bonds, or even bank investment based interest rates are higher. We may have just seen a move from investors to re-allocate assets to move away from the pricey equities to other bonds/other instruments that may have more returns to give in an environment when inflation and economic growth is on the rise. ❔Is the correction as a result of this re-allocation ‘normal’❔ ✅I would say yes, especially if we think about the prices of many of the stocks in the market. 🚀 Most tech and green energy companies (Good examples: $PLUG (Plug Power Inc) or $SUNW (Sunworks Inc) ) have been trading at a P/E ratio that is incredibly high. When P/E’s are as high as they have been, it can take anything as small for investors to take a hard look asset allocation. A high P/E can only have two outcomes – 1️⃣ The earnings of companies grow at a rapid pace to meet their current price valuations, or 2️⃣ The stock prices drop to meet what is realistically achievable from an earnings perspective. My view – The market has reacted to 2️⃣ The market may have more room to fall, but this has been in the offing and should help level some of the stock prices at values that are more in-line with earning potential.