Between last Thursday’s open and this Tuesday’s close, the S&P 500 fell 6.5%, which was a surprising move triggered by a big decline in tech stocks.
If you have been watching the financial press, you have probably already heard the speculation that the decline (and much of the previous rally) was triggered by some extremely large options trades the venture capital firm Softbank (OTCMKTS:SFTBY) conducted.
Daily Chart of the S&P 500 — Chart Source: TradingView
We feel that the fundamentals are still stable — in the short term, at least — and a consolidation like the one we experienced in June is the most likely outcome over the next few weeks.
So, this week, let’s discuss the Softbank trade in a little more detail and why its effects don’t represent serious weakness in the market.
What Did Softbank Do?
Essentially, the investment firm Softbank bought and sold options to create a net exposure of around $50 billion in mostly large-cap tech stocks like Apple (NASDAQ:AAPL) and Facebook (NASDAQ:FB).
Interestingly, rather than creating a position like that in a private deal through swaps or custom options with other large institutional traders, the firm created a large percentage of the trade in the regular options market.
Once traders figured out what was going on, some started to fear that the rally in tech could have been the result of a single entity’s actions rather than a consensus among bullish investors. If that was true, then it makes sense for traders to discount those stocks from their inflated prices to account for a higher level of uncertainty.
This is all bad news for Softbank, and investors in large tech — like us — are frustrated as well.
However, to us, this looks like a trade designed to take advantage of mis-pricing in the regular markets, where option values were cheap compared to custom options that would have been available from institutional counterparties like JPMorgan (NYSE:JPM) or other large banks.
This happens when an investor (Softbank) sees prices that represent an unusual “deal,” and they step in to take advantage.
If we are correct, it is still true that this was a surprisingly large trade, but it seems extremely unlikely that it was just a big gamble to make up for losses Softbank accumulated from its terrible investment in WeWork.
Additionally, if options have been undervalued in the regular markets, then we should see a general increase in premiums, which would benefit us when we open new short puts and covered calls.
The Technical Picture
As we mentioned last week, the S&P 500 was nearly at its 61.8% projection target based on the consolidation in June. While we didn’t expect a 6.5% selloff in just three days, some profit-taking at a key target like this is normal.
It looks very similar to the disruption that started on June 11 when traders had a mini panic attack about infection rates related to the novel coronavirus pandemic. The consolidation that started in June extended through July 15 when investors cheered new information about a vaccine from AstraZeneca (NYSE:AZN).
Sensing a theme?
We expect a repeat of that consolidation in the market this time as well. After all, we saw most of the same issues emerging in the run-up to the recent selloff.
- Implied volatility levels, a measure of market fear, had been rising just before the drop.
- Transportation stocks were already declining or were lagging the major indexes.
- High-yield bonds — one of the most accurate leading indicators — were in decline or flat prior to the decline.
Other similarities include a high level of anxiety about the Covid-19 pandemic, high new unemployment claims, and uncertainty about stimulus from the government. In the following chart, we have compared the June-July consolidation with what that might look for us now, so you have a sense of the likely timing.
Daily Chart of the S&P 500 With June-July Consolidation Marked — Chart Source: TradingView
Of course, we should readily admit that if the underlying fundamentals are still stable, then buyers may want to move in more quickly, which could accelerate a bounce.
Our estimates for a recovery after the March-April decline were bullish, but we still only expected the S&P 500 to be trading around 3,000 at this point in the fall, so we could be a little too conservative this time as well. We recommend staying flexible to make adjustments as needed.
The Bottom Line
Now that the S&P 500 has hit the target we discussed last week and started to pull back, we are looking ahead for any potential catalysts that could stabilize prices and strengthen support in the 3,200-3,300 range. From that perspective, we see two events that could go a long way to improving investor sentiment and calming the market.
Republicans in the U.S. Senate have introduced a new stimulus bill that is much smaller than the one forwarded by Democrats in the House of Representatives. Although it is smaller, the bill would still re-initiate extra weekly unemployment benefits, though, at $300 a week. That is down from $600 a week, but it is still extra money.
The bill also includes loan support for small businesses and an extension for a portion of the Paycheck Protection program. Whether this exact bill is finally passed in September is uncertain, but we expect investors to see this as a positive for consumer spending, which should help stock prices.
Next Tuesday, FedEx (NYSE:FDX) will report earnings, which is usually a good bellwether for business activity and spending. The last mid-earnings season report from FDX on July 1 helped kick off another buying frenzy as investors cheered higher than expected consumer and business deliveries. Another positive report would go a long way to helping stocks stabilize in September.
On the date of publication, John Jagerson & Wade Hansen did not hold (either directly or indirectly) any positions in the securities mentioned in this article.
John Jagerson & Wade Hansen are just two guys with a passion for helping investors gain confidence — and make bigger profits with options. In just 15 months, John & Wade achieved an amazing feat: 100 straight winners — making money on every single trade. If that sounds like a good strategy, go here to find out how they did it.
