It’s been a bad week for American equities, as the Nasdaq logged one of the worst days in more than two years, sinking a whopping 4.08% during yesterday’s trading session. The Dow suffered a similar fate as well, dropping 3.09%. Seemingly no companies were safe, as only 16 stocks out of the entire S&P 500 ended up with a positive gain on the day.
The last time the Nasdaq saw such a steep plunge was in June of 2016, when the U.K. voted to free itself from the European Union – now dubbed “Brexit”.
While the market didn’t slump quite as dramatically as back then, the major drop yesterday killed-off any hope of the market setting new all-time-highs in the coming weeks. The recent rally – which was driven by corporate tax cuts, an outstanding earnings season, and an encouraging jobs report – has finally sputtered, leaving many investors wondering what happened, and why stocks are taking such a beating.
There are several different theories out there that try to explain yesterday’s selling-spree, and while many of them may be in the ballpark of identifying the root cause, I believe that they haven’t totally explained the three major reasons that the market fell so sharply yesterday:
1. Bond rates are gaining rapidly
Bond yields, which increase as bond prices fall, have investors shaking in their boots – afraid that the rising rates will lead to slimmer profit margins for U.S. corporations. Because these companies finance their growth through debt, rising interest rates will make it costlier for them to repay loans, cutting into earnings.
In addition, stocks are often evaluated with the discounted cash flow method – which discounts future cash flow projections to estimate what a company is currently worth. Analysts who use this method rely on 10-year Treasury note (bond) yields in order to discount cash flows. So as yields go up, stock valuations decrease.
That’s why so many investors are worried about the current 10-year Treasury note yield, which is approaching a seven-year high. As it continues to climb, it will continue to torpedo share prices across the board.
And as bad as that is for equities, it probably wouldn’t have been enough to sink the whole market all on its own.
That leads me to major reason number two…
2. FAANG stocks take a dive
The FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) all ate huge losses yesterday, as these companies are basically the biggest borrowers in the world at the moment – thanks to their absolutely massive market caps. Because they rely so heavily on debt, even small increases in bond yields can punish share prices – and that’s exactly what happened.
However, the damage wasn’t limited to just FAANG corporations yesterday, as the entire market dropped – so why did other stocks (that don’t have tons of debt) get hurt as well?
FAANG stocks (a total of 5 companies) currently account for 13.9% of the S&P 500’s total market cap, so a drop in share prices among those corporations can quickly shift investor sentiment. As the FAANG fell, so too did other stocks caught up in the wave, selling-off one after another.
And as much sense as that makes, I still think that there was one final reason that the market suffered such a large drop yesterday…
3. The major indexes just hit all-time highs
Until last week, the stock market was on an absolute tear. Investors were spitting money into blue-chip stocks and riding the wave for months, just waiting for a signal to get out and collect their winnings.
Well, if they needed a sign to sell, they certainly got one yesterday morning. The market had opened down on the day, and quickly descended even further – led by the coalition of FAANG corporations.
Investors, who were coming to terms with the high interest-rate world we now live in, cashed in their winnings en masse, dumping their long positions.
I mean, could you blame them? The market hasn’t exactly had the greatest quarter since it began on October 1st, andall the experts have been predicting a large correction in the near future.
Could this finally be it?
Possibly, but before the chicken littles of the world kick up their “sky is falling” rhetoric, lets at least give equities a chance to breathe before officially declaring them dead – because in the end, this could all just be a hiccup in what is a minor-sell off after hitting record highs.