This notable and dramatic divergence in performance can be explained by the FAANGs perceived safe haven status, given high cash levels and a business model that is particularly suited to the coronavirus, and before that to a world of low inflation and low interest rates. Surging liquidity and the fear-of-missing-out further exacerbated this trend.

In The Bigger They Are The Harder They Fall we explained that, despite positive underlying fundamentals, valuations in this space had become extreme. At the time we showed that the top 5 companies in the S&P 500 (the FAANGs) represented over 22% of total market capitalisation which represented the highest market concentration in over 30 years. This concentration, in just a handful of names, is not healthy and points to narrowing market breadth, which has historically been a strong indicator of subsequent market drawdowns. As a result, we booked some profits by bringing our US tech position back to model weight. Later that month we booked additional profits, reducing the position further.

Fast forward to early September and some of our earlier misgivings seem to make sense. In an FT article published Friday, SoftBank has been unmasked as the mysterious ‘Nasdaq whale’ responsible for driving US tech stocks to extreme levels (before the sharp sell-off on Thursday and Friday last week) by buying billions of dollars’ worth of call options – ‘which give the user the right to buy a stock at a pre-agreed price’. The article refers to a number of sources who described SoftBank’s alleged actions as ‘huge’, ‘dangerous’ and ‘the largest ever trading volumes in contracts linked to individual companies’ on record.

Due to the dynamics around options trading, to hedge investment exposure, the counterparts to these trades will have bought stocks in the market. This creates a self-perpetuating feedback loop between Softbank buying call options and dealers buying stocks causing tech stocks to rise in price. This dynamic explains why implied volatility for the Nasdaq 100 had been rising throughout August even as the underlying index also rose in value. Simultaneous increases in both equity and volatility are unusual and can be a cause for concern.

This is shown in the chart below which shows prior instances where volatility and equity index correlations have turned positive (bottom panel) and how this is consistent with periods of risk aversion in the index (white line).

What goes up can come down, and the key risk is that if Softbank starts to unwind these trades, the feedback loop can easily turn negative. This is especially true for crowded trades and to that extent it is somewhat disconcerting to note that ‘long US tech and growth’ remains the most crowded trade, for the fourth consecutive month, according to the latest Bank of America fund manager survey. This is compounded by the rising number of retail investors also participating in the trade via online trading platforms such as Robinhood which offer commission free trading. Historically, when small traders become overly enthusiastic it typically signals a potential market top and impending correction.

One source, referenced in the article, expects SoftBank’s ‘buying to resume’ given the more damaging risk to the strategy from ‘a larger and longer-lasting stock market decline’. This makes sense but give the position is now public knowledge my concern is other players may look to exit as they realise prior gains were not broad based or sustainable in nature but rather short-term speculative market bets. At an extreme, this could also incentivise speculative short selling to try and squeeze SoftBank’s position, as speculators have someone to cover their positions.

Whatever the outcome, valuations have become distorted by the actions of one large player in the derivatives market. The market may well take this news in its stride, but these things rarely end well, and it is likely that US tech stocks could be entering a period of elevated volatility. Having pre-emptively reduced exposure to US technology we think the best strategy is to monitor the situation, remain cautious and continue to exercise our disciplined approach to risk management. If we do see a larger correction, we would view it as a healthy development and a potentially attractive opportunity for re-entry.    

Key events impacting risk sentiment this week include ongoing trade negotiations between the UK and European Union, 10 and 30-year US bond auctions, Chinese and US inflation data and Thursday’s policy decision from the ECB.