Podcast Summary
Market corrections: Market corrections, such as recent declines in Japan and the US, are normal parts of the market cycle, but high evaluations and geopolitical instability can exacerbate them. Selling during market corrections could result in missing out on potential huge returns during the rebound.
Recent global stock market volatility, specifically the significant declines in Japan and the United States, should not come as a surprise despite the extended period of low volatility. The sudden sell-offs in Japan, with the Nikkei 225 experiencing its worst two-day decline in history, and the United States, which saw its worst three-day streak of returns in August, are part of normal market corrections. However, high evaluations and geopolitical instability can exacerbate these declines. Despite the fear that spread among investors, it's essential to remember that corrections are a normal part of the market cycle, and selling at the first sign of trouble could result in missing out on potential huge returns during the rebound.
Market crashes: The probability of a significant market crash is low, but market volatility can still cause panic due to unexpected macroeconomic data, which may not accurately reflect the overall economic picture.
Despite small market falls happening frequently, the probability of a significant market crash, defined as a 30% or greater fall, is very low. However, even though the likelihood is low, market volatility can still cause significant panic, as seen in the recent spike in the VIX index, which reached levels not seen since the 2008 financial crisis and the start of COVID. This panic was likely caused by unexpected macroeconomic data, specifically the US employment numbers, which showed an unexpected increase in unemployment, despite the Federal Reserve's previous rosy outlook for the economy. The increase in unemployment was due to a higher participation rate and an influx of immigrants in the US labor market. Despite the market volatility, the overall economic picture is not necessarily bad, and the market interpretation of the employment numbers as a catastrophe may not be accurate. The market is "data dependent," not "data points dependent," meaning that the overall trend of the data is more important than individual data points.
Carry Trade Unwinding: The unwinding of the carry trade, a popular investment strategy involving borrowing cheap in low-interest countries and investing in higher-yielding markets, could lead to market volatility due to the recent decision of the Bank of Japan to end interest rate yields on some of its bonds.
The economy is experiencing a slowdown, as indicated by a contraction in manufacturing activity and struggling retailers. However, the labor market remains relatively strong, and the Federal Reserve has the ability to stimulate the economy with interest rate cuts if necessary. The stock market's resilience despite the tightening of monetary policy is also noteworthy. Meanwhile, the severe and sudden fall in the Japanese and Asian stock markets can be attributed to the unwinding of the carry trade, which involves borrowing money in low-interest countries and investing it in higher-yielding markets. It's a simple concept of borrowing cheap and investing where returns are higher. This has been a popular strategy, especially for hedge funds. The Bank of Japan's recent decision to end interest rate yields on some of its bonds could accelerate the unwinding of this trade, leading to market volatility. Overall, the economic landscape is complex, and various factors are at play, requiring a nuanced understanding of the situation.
Carry trade unwinding: The unwinding of a large carry trade, driven by unexpected interest rate hikes from the Bank of Japan, led to market volatility and forced selling, impacting various markets, including Japanese stocks.
The recent market volatility can be attributed to the unwinding of a large carry trade, driven by the Bank of Japan's unexpected interest rate hikes. This trade involved borrowing cheap yen and investing in higher-yielding assets, often in emerging markets. However, when the Bank of Japan raised interest rates, the value of the yen appreciated, making it more expensive for investors to maintain their positions. This led to margin calls and forced selling, causing a ripple effect that impacted various markets, including Japanese stocks. The sudden shift in monetary policy from the Bank of Japan and the Federal Reserve, which was expected to cut rates, created a large interest rate differential, contributing to the yen's strength and the resulting volatility. The markets had been heavily positioned for low volatility and cheap borrowing costs, making the unwind all the more significant. While the focus has been on Japan, the potential for further market instability exists, especially if there are unexpected events or hidden pockets of leverage.
Fed's shift in focus: The Fed's decision to hold rates steady despite market expectations signals a renewed focus on unemployment in their dual mandate, while the psychological impact of previous rate cuts may have diminishing effects.
The Federal Reserve's decision to hold rates steady despite market expectations for a rate cut signals a shift in focus towards unemployment in their dual mandate. The markets had been pricing in a higher likelihood of an emergency rate cut due to economic uncertainty and volatility, but Jerome Powell and the Fed have historically been cautious about reacting to market expectations. The psychological impact of the initial rate cut in December 2018 was significant, but subsequent cuts have had diminishing real-world effects. The yield curve has shifted down in response to the market sell-off, and bonds have provided some hedging for equity investors. Despite the current economic turbulence, the global economy is not in as bad shape as some fear, and a correction to the 10-year average could even be healthy for long-term returns. It's important for investors to stick to their asset allocation plans and remain calm during market volatility. The ongoing Q2 earnings season is showing strong growth, with analysts forecasting continued growth in the second half of the year.
Market risks: Markets face potential risks from global growth disappointments, financial accidents, geopolitical tensions, and a disputed US election, but economic and fundamental data support continued growth. Dollar cost averaging is a more effective investment strategy than 'buy the dip'.
The current market situation does not indicate an earnings recession for US companies, and the economic data along with the fundamental data of companies is supporting the markets. However, there are potential risks such as global growth disappointments, financial accidents, geopolitical tensions, and a disputed US election that could lead to market volatility and potential market crashes. It's important to note that markets often experience heightened volatility following significant events, and it's not possible to predict market crashes. Instead, it's recommended to stay informed, have a plan, and consider seeking advice from financial professionals. Additionally, the "buy the dip" strategy, where investors hold cash and wait for a market correction before investing, may not be the best long-term investment approach as it could result in missed opportunities and holding cash for extended periods. Instead, dollar cost averaging, where investors regularly invest a fixed amount into the market, regardless of market conditions, is generally considered a more effective investment strategy.
Market timing: Market timing doesn't consistently outperform. Maintaining a diversified portfolio and rebalancing periodically can help improve risk-adjusted returns, but comes with the trade-off of underperforming in the long-term. Focus on creating a well-diversified portfolio that aligns with risk tolerance and investment goals.
Attempting to time the market by holding cash in wait for crashes and then investing when valuations are cheap doesn't consistently outperform. Instead, maintaining a diversified portfolio with stocks and bonds, and rebalancing periodically, can help improve risk-adjusted returns. However, this strategy comes with the trade-off of underperforming in the long-term. Additionally, designing an investment plan based on market crashes or rare events can be psychologically challenging and potentially lead to missed opportunities. It's essential to remember that investors cannot control market movements and should focus on creating a well-diversified portfolio that aligns with their risk tolerance and investment goals.