Quotes of the Day: Beware the “Self-fulfilling Mechanisms”

Just began digging into the latest Bank for International Settlements Quarterly Review (always a must read, but only if you’re, like me, a total geek), released yesterday, and can’t help but quote from the opening few paragraphs, as they so echo what you’ve been reading herein the past months:

“Financial markets recorded further gains during the review period, despite the challenging macroeconomic outlook. A divergence emerged between, on the one hand, elevated stock valuations and tightening credit spreads and, on the other, the reality of an economic recovery that looked incomplete and fragile.”

“The gains were largest in the United States and China, whose main equity benchmarks by August had surpassed their prepandemic valuations, which had already carried signs of overheating.

“The evolution of aggregate valuations appeared to be somewhat at odds with the general economic outlook.”

“…despite some upward revisions, growth forecasts for the global economy remained generally tepid, anticipating that recent GDP losses would not be recouped before the end of 2021. Furthermore, corporate earnings expectations were revised downwards, sometimes significantly, in some of the largest AE markets.”

“…less than half of the stocks included in the S&P 500 index had surpassed their February prices before the sell-off started. By that time, the top six technology firms had exceeded their mid-February prices by about 40%. Meanwhile, the rest of the index did not catch up, despite its components increasing by more than 50% from their deep trough.”

“Investors’ exuberant sentiment about specific stocks in the technology sector is likely to have fed on itself. Bets that the rally was set to continue led to heavy long positioning in call options. In such transactions, dealers typically seek to hedge their positions by purchasing the underlying stock, which boosts its price and validates the initial bets. As such self-fulfilling mechanisms also work in the downward direction, they tend to be destabilising.”

That last sentence is about an unwinding that will likely prove difficult to avoid… 

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