Normally, I write these columns on Monday. But yesterday was an extraordinary day that deserves some post-closing remarks. Let me start by putting the word extraordinary into some context. The drop of over 1000 points in the Dow and an even larger drop in the NASDAQ Composite was only extraordinary compared to recent trading. Back in March 2020, during the height of Covid fears, the Dow fell over 2000 points three times. But what was unusual, even extraordinary about yesterday is that virtually all markets covering all financial assets declined in unison.
Every storm seems to have an epicenter. Yesterday’s was located in Tokyo. If you hadn’t noticed, while our stock market was setting new highs, its ascent paled in comparison to the strength in Japan. You and I may not have been paying that much attention to Japan but big traders and hedge funds were making a ton on money playing the yen carry trade. Japan’s demographics have been terrible for decades. Population wise the country is shrinking. Any GDP growth is hard to achieve. But with that said, its current government has been more stimulative than any since the 1980s. Japan started to achieve positive GDP growth again. And it did it with only a touch of inflation and very low interest rates. What a wonderful combination; growth, low costs of capital and modest inflation. Global investors, seeing that trio, started to borrow cheaply in yen and reinvest the money in higher yielding bonds around the world.
Like all successful trading strategies, it worked until it didn’t work. What changed? The yen soared. Japan is always a big trader. The soaring yen upset the balance of payments and allowed inflation to creep in. Japan’s central bank responded by raising borrowing costs just as other nations were starting to cut rates. The yen carry trade began to unravel.
Needless to say, while the trade was working, hedge funds and others used leverage to accelerate returns. That works great on the way up. But when the trade no longer works, the rule book says to sell and deleverage.
The VIX is an index that measures volatility via the size of option premiums. More volatility equals higher premiums. For many months, the VIX was dormant, hovering below 15, a historically low number. By yesterday morning, it touched 65, a number that has only been exceeded briefly in October 2008 during the height of the Great Recession panic, and in March 2020 as everything was being locked down for Covid. Some big hedge fund traders like volatility. Most don’t.
As the yen carry trade reversed, leveraged traders had to sell. Yesterday, the Nikkei had its worst day since Black Monday 1987. It fell more than 12%. The first echo was in Korea, which fell 8%. When European markets opened, they immediately fell 4%+. The way to react to selling pressure is to sell and move to cash until the dust settles. What was extraordinary about yesterday is that everything caved in simultaneously. Stock prices fell. Commodity prices plummeted. Bond priced declined. Even bitcoin, advertised as a haven of safety in a world where governments cheapen all currencies, fell by more than 12%.
But with all that said, U.S. stock markets fell 2-4% at the opening in response to all the selling worldwide and stayed within a relatively tight range all day. There wasn’t panic. The unwinding of the yen carry trade didn’t start yesterday. Markets have been teetering for a couple of weeks and fell both last Thursday and Friday as the VIX started to climb, touching 30 on Friday at one point. But it appeared that once the tidal wave hit the U.S. its strength started to dissipate.
This morning, the Nikkei rose by over 9%. In points, it is the best day in Japanese stock market history. But it didn’t completely offset Monday’s losses. Bond markets are rebounding as well. The 10-year Treasury yield recovered by about 10 basis points. But it hasn’t recovered anything near the cumulative declines of the past three trading sessions. European markets are opening flat and U.S. futures are up slightly.
After a tsunami hits, recovery isn’t instantaneous. In down markets, Mondays are often the worst. Black Monday isn’t a singular event. It occurred yesterday in Japan. It occurred in the U.S. in 1929, again in 1987, when the Dow fell a record 22% in one day, and it reoccurred multiple times during the Great Recession and during the Covid crisis. Conversely, if there is a good day of the week in down markets, it’s Tuesday. Tuesday bounces can be big but rarely undo Monday fiascos completely.
Our markets suffered from the unwinding of the yen carry trade. Business media also correctly pointed to a fairly weak employment report last Friday, a slowing in the pace of consumer spending, and a poor PMI report last week that signaled weakness in manufacturing as reasons for the market’s decline. Then, of course, there was the sharp correction of recent days in the high-flying tech names closely associated with AI.
But now it is important to put this all into perspective. The yen carry trade may not be over, but it certainly isn’t about to reappear as strong as it was just a couple of weeks ago. The Japanese stock market was overheated and needed a correction just as the U.S. tech sector was ripe for a correction.
Fundamentally, there have been a lot of subtle changes in our economic world. Growth is slowing. Whether that ends in a soft landing or a recession is still to be determined. The odds that the Fed’s first likely rate cut in September will be 50-basis points has increased, but it isn’t a certainty. There will be a lot of data between now and mid-September when the FOMC meets again. While financial markets unraveled yesterday, there are absolutely no signs that the economy is unraveling. Banks have strong balance sheets, consumer leverage remains within normal bounds, and there are no apparent systemic potholes like accelerated mortgage foreclosures. In fact, recent declines in mortgage rates may reignite some demand for housing in the not to distant future. There are few signs of layoffs although most companies have slowed or stopped hiring.
Markets have quickly gotten oversold. Expect some sort of a bounce this morning, but don’t make the mistake of thinking the correction is over. There are simply too many uncertainties. And despite the fact that the S&P correction is close to 10% while the NASDAQ correction is close to 15%, stock prices are simply not cheap yet. They are only cheap compared to three weeks ago. All the leading averages are still up for the year.
There is a lot of uncertainty. Will the Fed be too late cutting rates and cause the soft landing so desired to morph into a recession? Who will win the White House? Are our taxes going up or down? Will declines in job growth and the stock market affect consumer psychology? August and September are historically times where investors fret about the future. By mid-fourth quarter, some of these questions either get resolved or come into clearer focus.
August has just begun. Hopefully, yesterday is the worst single day. If we are headed for recession, that may not be the case. The good news, for now, is that there are few indicators that scream inflation. Even the creator of the Sahm indicator that everyone was talking about over the last week isn’t sure that we are on the cusp of recession.
Here’s what we do know. Inflation is on its way to the Fed’s 2% target. Further restrictive monetary policy to accelerate that move isn’t necessary. The Fed’s focus shifts to stabilizing economic growth above the flat line. We also know that Washington, fiscally, isn’t likely to do anything that impacts markets until early-mid 2025 at the earliest. Excess consumer savings have been spent. As credit card borrowing increases, some discretion has to be applied to future spending. Meanwhile the cumulative cost of inflation pinches lower income consumers.
Housing, auto sales, and retail sales are looked at as early cycle. All are impacted by changing interest rates. They are starting to go down. Mortgage rates are now falling toward 6%. As auto dealer lots fill up, deals will be forthcoming. We won’t see that impact immediately, but we should see some impact by year end.
Thus, while the panic of yesterday morning could subside soon, it’s way too early to sound the all-clear siren. For the most part, individual investors didn’t panic yesterday. Yesterday felt bad, in part because it was so sudden. But there are no green shoots to suggest a robust recovery toward record highs is at hand. If for no other reason, valuations are still not cheap enough to entice serious new buying. While some of the forces that accelerated declines late last week and yesterday seem less intensive this morning, the fundamental factors that ultimately dominate markets are still in that uncertain phase. That suggests we are still in for more volatility, perhaps with a near-term downward bias. For a true corrective bottom, we need to see more seller capitulation or signs of economic acceleration. What I see instead is a likelihood that future earnings estimates will be lowered and that market P/Es will continue to normalize. While I don’t see ingredients in place for a serious recession or major bear market, I don’t think the current correction has run its course. I will stick with my two-day rule that says stay on the sidelines until I see two strong days in a row.
Former NBA star and Olympic gold medal winner David Robinson is 59 today.
James M. Meyer, CFA 610-260-2220