Summary

• Recent Developments in Review
• Japan's Yen Reversal
• US Economy & Recession
• Perspectives on Market Moves

Rip Current Brings Summer Scare, Followed by Calmer Seas

A surprise interest rate increase in Japan plus fears that the US has fallen into recession caused a short-lived downdraft in stocks in early August.

Wild price swings in stock and bond prices can be worrisome. But the ebb and flow of the financial markets is a feature, not a flaw, and comes from traders and other short-term investors adjusting to new information.

A prudent response to financial market volatility for long-term investors:

1. seek to understand the causes
2. plan adjustments carefully
3. take action infrequently

Recent Developments in Review

The financial market rip current that I highlighted in my letter last Saturday increased markedly in intensity.

From the start of the trading day on Thursday, August 1^st to the open on Monday, August 5^th, US large-company stocks fell by 7.1%

Overseas, volatility was much higher. Japanese stocks fell by 12.4% in a single day (Monday) as measured by the Nikkei Stock Index.

A 7% decline in US stocks at some point during the year is normal. There are typically 3 – 4 pullbacks of between 5% - 10% each year (as the first chart below illustrates). But the speed of the most recent decline, occurring in just over two trading sessions in the US and in one day in Japan, was surprising.

I can discern two causes for the disruption: a surprise interest rate increase in Japan and elevated concerns about a recession in the US.

Neither development requires a response from long-term investors.

Japan’s Yen Reversal

The initial catalyst for the stock market selloff came from the far east. Japan’s Central Bank, the Bank of Japan (BoJ) lifted its short term “policy” interest rate to 0.25% on July 31. This was only the second time in nearly two decades that the BoJ has moved rates up.

And the BoJ Governor’s comments following the interest rate increase seemed to indicate that more interest rate increases are on the way.

Big Wall Street firms and other global trading outfits had been involved in something called the “Yen carry trade”, where they have borrowed in Japanese Yen and reinvested outside of Japan, typically in US bonds, but also in US stocks.

The profit these traders were making (by borrowing at low rates and lending or investing for a higher return) was referred to as “carry”.

As a result of the BoJ’s interest rate increase (and suggestion that more increases would be coming soon) the value of the Yen vs other currencies shot up and caused a rush for the exits from the carry trade because the cost of the Yen loans went up.

Many traders closed out their "Yen carry trades" which involved selling the assets that were financed by the Yen loans, including US stocks, and then paying off those Yen-based loans.

It’s difficult to gauge the size of the Yen carry trade, in part because participation has been wide-spread, and because there aren’t publicly available data sources that catalogue it.

However, strategists at JP Morgan, the world’s biggest bank, estimated that by Wednesday, August 7, three quarters of the Yen carry trades had been closed. The end of the Yen carry trade was one of the causes of the big selloff in US stocks. The negative effects from the Yen carry trade on the US stock market are very likely temporary.

US Economy and Recession

The second catalyst that pushed stocks lower was rising concern that the US economy is about to slide into recession. I’ve dedicated a fair amount of time this week exploring this issue by reading various research reports, digesting news articles, and participating in conference calls with well-regarded economists.

The bottom line: US recession fears are overblown.

The data release that raised alarm bells came on Friday, August 2. The Bureau of Labor Statistics’ (BLS) monthly employment report showed that the labor market is losing momentum at a faster than expected pace. Although the unemployment rate is still historically low at 4.3%, it has risen by 0.6% since January.

Claudia Sahm, an economist, designed an indicator to provide a real-time signal of the onset of recession, using the three-month moving average of the US unemployment rate. It has accurately signaled all twelve US recessions since 1947.

The “Sahm Rule” was triggered by the BLS data release, indicating that the US is either in recession now, or about to fall into recession.

Since stocks typically do poorly when the economy turns down, short-term traders took the triggering of the Sahm rule as a signal to sell stocks.

Interestingly, in an Opinion article published by Bloomberg on August 7, Claudia Sahm had the following to say about her own rule: “The US is not in a recession, despite the indicator bearing my name that says it is. The Sahm rule joins a long list of economic tools skewed by the unusual disruptions of the past four and a half years.”

Sahm goes on to say that her rule is, nevertheless, still relevant and that the risk of a US recession is elevated.

US economic developments bear watching closely. The higher interest rates that we’ve been experiencing during the past eighteen months are an important factor likely acting as a brake to slow economic momentum.

However, there are other high frequency indicators, such as retail sales, hotel demand, air travel, and restaurant bookings, that point to continued expansion of the US economy.

My interpretation of these developments: it’s unrealistic that one data series is going to accurately forecast the direction of something as complex as the US economy.

And, absent a crisis (such as financial meltdown like 2007 or health event like 2020), changes in the US economy are more likely to unfold over many months, rather than overnight.

Perspective on Recent Market Moves

By Friday, August 9, a semblance of calm had returned to the US financial markets, with positive price action on Tuesday, Thursday, and Friday which counterbalanced declines during the four other trading days so far in August.

The chart below helps put stock market declines into perspective. Researchers at LPL Financial considered data from 1928 – 2023 and determined the average number of times per year large company US stock declines of a certain magnitude occur.

For instance, stock market dips of greater than 3% (up to 5%) have occurred 7.2 times, on average, each year going back to 1928 (top bar). Pullbacks greater than 5% (up to 10%), like the move that just happened, occur on average 3.4 times per year.

Source: LPL Financial

The chart above shows that stock market down-moves of 3% - 15% are a normal, recurring part of investing. Down-moves of greater than15% are less frequent occurrences.

Even though the data says its normal, sharp, quick downward movements can still cause confusion, and even fear, because they can result in large (though usually temporary) drops in portfolio values.

So, if you’re feeling anxiety about a sudden drop in your portfolio’s value, it’s also good to remind yourself that the likely path for the stock market, following down moves, is recovery. Especially when the economy is creating jobs and growing.

The chart below from Goldman Sachs illustrates this point. Goldman Sachs researchers observed 21 corrections of around 10% since 1980.

Source: Goldman Sachs

Here’s how to interpret the chart above, using the bars to the far right as an example: on average, when a 10% correction happens during a time of economic expansion (like today), stocks are likely to be 11% higher (on average) during the next year (sky blue bar).

If the correction happens during a recession, stocks on average are likely to be about 0.5% higher (dark blue bar).

The grey dot in the chart above indicates that 70% of the time, following a 10% correction, stocks are higher in 12 months’ time.

While I recognize that unexpected drops in portfolio values are disconcerting, I hope you’re able to take some comfort in the fact that markets tend to be resilient, and portfolio values tend to recover, if you stay the course with a well-diversified portfolio.