A year notable for its lack of volatility and strong stock market returns was turned upside down the past few days as volatility spiked and stock prices fell globally. Investors got a preview that it would be a tough to start to the week when Japan’s Nikkei Stock Average fell 12.4% on Monday, its worst day since 1987.
In the US, selling pressure was widespread as all major indexes saw month-to-date losses through August fifth. The large cap S&P 500 was down 6.1% while the small cap Russell 2000 was down 9.7%. The Nasdaq was down 7.6% and entered correction territory from all-time highs set in July.
The market’s fear gauge, known as the VIX, spiked over 65, the third highest reading ever behind the Great Financial Crisis and COVID crash, before settling into an elevated but less alarming number of 37.
Bad stock market news started on Friday when the monthly jobs report saw weaker than expected jobs gains and the unemployment rate rose to 4.3%, its highest level since October 2021. While this data all but assured the Fed would cut rates in September, the narrative around the Fed quickly shifted to concern they were behind the curve.
This bit of news by itself, however, likely wasn’t enough to spark the magnitude of the selloff. There are other significant considerations in play for the market downturn, such as the unwinding of the Japanese “carry trade” due to the surging value of the yen. A carry trade is an investment strategy where an investor borrows money in a currency with a low interest rate and then converts it into a different currency or asset with a higher interest rate to earn the difference. For example, an investor might borrow in Japanese yen at a low interest rate and invest in U.S. bonds that offer higher returns. The profit comes from the interest rate differential between the borrowed funds and the investment returns.
This trade, however, carries significant risks, including currency risk and the potential for sharp declines in the value of the invested assets. This is how it is currently playing out:
In short, this unwinding of the yen carry trade is contributing to broader market uncertainty and fear, as it affects multiple asset classes and currencies simultaneously. The full scope of the implications of this unwinding are unknown, but if the market hates one thing it is uncertainty. And this is a new bit of uncertainty on top of these other recent developments that have created a negative market reaction.
While the reasons for the selloff paint a pessimistic outlook for the stock market, there is still strength within the economy and positive trends that suggest the current downturn and volatility could be temporary.
Philosophically, one thing you can count on is that we will not overreact to market news and will remain 100% committed to our investment strategies, which have weathered previous downturns and periods of volatility. An important part of our investment model is anticipating and addressing market volatility.
For example, most of the year, our primary investment strategy has carried a sizeable bet on small-cap stocks. While the top 500 largest companies make up about 90% of the market capitalization of the stock market, we maintained a 60-40 allocation large to small/mid-caps. In June, we made the decision to come off that lean a bit to 70-30. While small-caps did well in July, this move lessened exposure to the small-cap decline occurring this month.
We also turned off the “risk-on” version of our stock selection model earlier this year as we determined the downside risks of keeping it on outweighed the potential upside. Stock selection in portfolios is now informed by our standard model that holds up better during selloffs.
For our Wealth Management clients in one of our asset allocation models, we recently deployed some significant adjustments based on market conditions (link to our recent asset allocation blog post). These changes, especially increased exposure to fixed income and alternatives, helped our clients during the recent volatility.
Moving forward from here, we will continue to monitor the changing stock market environment but will let the dust settle before making any major moves. Market volatility does provide the opportunity to add value through tax-loss harvesting and rebalancing, which our traders actively monitor year-round.
The reassuring thing about being a long-term investor is that you don’t have to participate in potentially irrational markets. While carry traders experiencing margin calls are forced to sell into this negative market, long-term investors can simply stay the course and let calmer heads prevail.
As Paul Samuelson quipped, the stock market has predicted nine of the past five recessions, after all.
Many investors carry cash on the sidelines but struggle to pull the trigger on investing it for fears they are buying in at a market top. Stocks are now at a discount to where they were at the end of July. If you are in this group, this could be the buying opportunity you were looking for.
We offer a complimentary portfolio analysis to help identify the strengths and weaknesses of your portfolio. If you want us to perform a customized review of your holdings, reach out here.