We partner with Horizon Investments, which helps provide data, research, and perspective for our Investment Committee to develop and craft portfolios. They had some excellent information about last week's stock market drop. We want to tell our clients that part of our value is that we monitor the markets, so you do not have to. I like to say you want someone awake at the wheel. That is why our Advisors, who also serve on our Investment Committee, constantly do research.
The first week of August started with a bang: The S&P 500 dropped 3% last Monday, its most significant one-day decline in nearly two years—amid growing fears that July's slowdown in hiring could spark a recession. Investors feared the anticipated economic soft landing might become a crash, dragging stocks down. The VIX—known as Wall Street's "fear index"—spiked from around 23 to an intraday high of 66 before settling at a still-elevated 38.
A key reason for all this excitement was an employment report showing fewer jobs were created in July than expected, although not enough to signal a significant problem in the labor market. If that seems odd, you're not alone. Big spikes in the VIX—an index that essentially measures expected future stock market volatility—tend to occur when extremely significant events unfold.
The VIX soared from approximately 14 to over 80 in 2020, when it became clear that a global pandemic was rapidly developing. Other notable moments include the 2010 European debt crisis that threatened the global financial system and the September 11 attacks.
The most recent central economic data point—the July jobs report—showed hiring being slightly weaker than expected. The July report fell short of expectations only after the surprisingly high numbers we saw in March and May. The difference between expectations and actual results in July was about the same as in April. In the bigger picture, these deviations are average and suggest that the job market is becoming more balanced. This is significant because a tight labor market was the primary reason the Fed wasn't cutting interest rates.
The obvious question, then, is why so many investors stampeded for the exits during the past few days.
We see the market's overreaction as driven by professional investors needing to unwind their positions in popular trading strategies at precisely the wrong time: during the illiquidity of late summer. Examples of these positions include:
- Technology Sell-Off: Most stock market gains last year have been through tech companies such as Alphabet (Google), Apple, Amazon, Microsoft, Nvidia, Meta (Facebook), and Tesla. They are known as the Magnificent Seven. Investors rushed away from the safety of these mega-cap companies in favor of cyclically sensitive sectors that benefit from lower rates, such as regional banks. Investors started to question how the reality of AI compares to elevated expectations and lofty valuations - a byproduct of the unprecedented market concentration we have seen this year - sellers sitting on large gains tried to lock them in just as market volatility was on the rise.
- Yen Carry Trade: Shocks from stock positioning then rippled into one of the more popular macro strategies for the last few years, the yen carry trade. While seemingly complicated, it is relatively simple. Investors borrow money in the near-zero yielding Japanese yen and buy higher-yielding currencies such as the U.S. dollar, Mexican peso, or the Great British pound, hoping to pocket the difference in interest rates. This activity drove the yen to fragile levels, and when the Bank of Japan raised rates last week - a mere 15 bps to 0.25% - it triggered an unwind of this trade. The Japanese stock market wasn't spared either; the Nikkei fell almost 20% in three trading sessions.
- Stock Volatility and Dispersion Trades: The Volatility Index (VIX) hit pre-Covid lows on May 21 and started at around 12 (a relatively low point) in July. During this same time, we saw the so-called "dispersion" trade, where hedge funds seek to take advantage of individual stocks' volatility versus the overall index. These positions helped drive the implied correlation in the stocks in the S&P 500 to almost zero by mid-July, with the recent uptick in option-selling strategies likely a contributing factor. As shocks spread through other parts of the market, forced unwinds in stock volatility trades led to the record's most significant single daily spike in the VIX.
These violent movements can understandably cause some panic among investors. However, we'd like to look beyond this volatility and maintain a rational perspective on what matters:
- The earnings season numbers overall show solid growth and positive outlooks, but high expectations have tempered a strong market reaction.
- The Fed's anticipated September start to interest rate cuts should finally provide some relief through the rate channel.
More importantly, we also want to return to one of our core principles, the bucket plan. The bucket plan has three buckets of: now, soon, and later. Your now bucket is for money you need within the following year. Your soon bucket is for the money you need within the next 2 to 10 years, and the later bucket is for the money you need for ten years or longer. The money you have invested in stock should be in your later bucket. You might have a little in the later part of your soon bucket, but that would be money for later stages like years 8 through 10. Any money you need in the short term should be outside the stock market.
The best long-term returns tend to come from investing in great-run businesses in the form of stock. However, volatility, like we just had last week, is one of the challenges with stock. That is why it should largely be in your later bucket so you can ride out the volatility.
You may be hearing a lot, and some of it may concern you. We generally encourage staying with your game plan. However, if you need to talk, we are always here.