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It’s early August, often referred to as the “Dog Days of Summer.” The term is rooted in Roman times. August generally means warm weather, family vacations and Stock Market volatility. It’s also wildfire and hurricane season. Last year saw selling start in August with a bottom put in October, which set up the multi-month run to new all-time highs. That’s been the normal seasonal pattern for decades. Of course, there’s little normal these days.
Japan was the center of attention to start the week. A 12% crash overnight sent stocks fleeing globally Monday. It was like a Tsunami-effect for financial markets. Then on Thursday, a powerful 7.1-magnitude earthquake struck off Japan’s southern coast, sparking a tsunami warning. Fortunately, there were no reports of death, serious damage or injuries. It sure set the tone for the tectonic shifts in the Market.
Monday was the biggest one-day loss for the S&P since September of 2022. It fell 3%. Fast forward to Thursday, it saw its biggest gain since November of 2022. The result, the S&P 500 finished roughly flat on the week. Those who weren’t paying attention might think nothing big happened. It was anything but that. Would you believe that after the 12% crash in Japan Monday, the Nikkei closed the week down just 2%? Fact.
The trigger for the sell-off was the unwinding of a very crowded position known as the Yen carry trade. Japan has had extremely low interest rates, even negative for a stretch, and speculators have feasted off borrowing Yen, converting to Dollars and buying higher-yielding assets. Much of the money fueled some of the Tech stock run. That got reversed quickly when the Bank of Japan raised interest rates for the first time in 17 years. The Japanese Stock Market suffered the most, but the impact was felt across the globe.
The VIX spiked to 65. That’s the fear gauge. It’s only the third time the volatility index ever cleared 60. The only other times were the Covid Crash in 2020 and the Financial Crisis in 2008. That created massive price moves, in both directions. The thing is, the VIX has traded below 20 for the better part of the last 18 months. It’s been a stable climb with benign volatility. No more. Above VIX 20, we should expect wide swings. We sure got it this week. Market enthusiasm shrunk.
Market crashes usually have the same set-up. People like a thing, so they buy the stock. It goes up. More people like it, so they buy more. So, it goes up more. It keeps going up and every dip is bought. Even more people become aware, and the crowd is feeling left out, so they join the party. The big risk takers decide to borrow money to buy even more of this thing, so they do. Eventually a large population of leveraged investors own a lot of the thing. There aren’t many more buyers to buy. Now something goes wrong with the thing. So, the price starts to go down. The brokers are worried, so the leveraged investors get margin calls forcing them to sell the thing to pay back their loans. Their losses mount, which forces them to sell other things, things that were fine, to pay back their loans on the thing that went wrong. The big leveraged investors who owned a lot of the thing that went wrong also all own the same other things, also with leverage, so there is a generalized crash in the prices of the things that big leveraged investors own. In a simplified manner, that’s basically what happened Monday.
Entering July, there was an estimated $14 Billion betting on the Yen falling against the Dollar. Much of it was unwound this week, but there’s still reportedly $6 Billion remaining. In the special case in which the big leveraged investors are banks, this sometimes leads to a contraction in credit and serious economic consequences. The Bank of Japan said it will ease rate hikes until stability returns. That brought some calm to the Market. However, central banks keep coming to the rescue. Speculators and the irresponsible never learn their lesson, so they keep doing it without consequences. A free market needs failures too.
The Stock Market was in correction mode already. At record highs in July, valuations were stretched and leadership was concentrated in just a few. The excesses are being corrected. Importantly, the cycle is maturing. Unemployment is rising. The Economy is slowing. Bond yields keep falling well below short-term interest rates. These are all signs of recession. There’s just no recession… yet.
The Market is clearly signaling a recession lies ahead, and the Fed is behind the curve. The Market is assigning 100% probability of a rate cut in September. It’s a coin-flip now between ¼-point and ½-point. It was 74% likely of a ½-point last week. Higher rates have choked off spending. That has gone a long way to fight inflation. Lower rates lower the price to borrow, for things like cars and houses. They stimulate economic activity, unless it’s too late. The Market has been signaling the Fed is too late.
We learn a lot about the Economy in Earnings Season. Disney certainly is a barometer for economic activity. The company reported a solid quarter but there are signs of slowing at their theme parks. That fits with the increasing concerns that the slowdown in consumer spending has finally spilled over to travel, which has been the dominant driver of strength post-Covid. What’s more, Airbnb said it is seeing slowing demand both at home and abroad. Management now forecasts the slowest pace since 2020. Cruise ships remain packed, but peak cruising might be on borrowed time.
The American consumer is getting squeezed. Since 2019, price inflation is up over 25% cumulatively. We see it at the store, restaurants, pretty much everywhere. The majority of Americans live paycheck to paycheck. Many use credit cards to pay for larger, discretionary items. They don’t all pay the full monthly balance though. Credit card debt in America cleared $1.1 Trillion for the first time. That translates to about $6,500 per person. The average interest rate on those cards is 20+%. Credit card debt can be a crusher. 9% of credit card balances have transitioned into delinquency as of June. That is definitely recessionary activity.
There’s nothing like price to change sentiment. Bullish sentiment was at multi-year highs in July, as the Stock Market kept hitting new record levels. No longer. The Investors Intelligence Bull/Bear spread dropped from its highest level since 2020 to a more neutral position. Additionally, the extreme option sentiment for Tech stocks, and specifically Semiconductors, has shrunk. It was at all-time speculative highs in July. Sharp sell-offs tend to spook speculators. They’re indeed corrective. Escalator up, elevator down. That’s the Market’s way.
This week’s volatility will likely last through August and into September. Things went from overbought to oversold quickly. Tech was primed for a bounce as the sector flashed extreme oversold conditions on Monday’s rout. But there has been some significant damage to the sector’s technical strength. Less than half of the S&P 500 Tech components are trading above their 200-Day Moving Average. The rotation of leadership has been quite pronounced. Would you believe that Utilities are up 7.5% in Q3 while Tech is down 9.5%? It’s true.
We still believe this is a correction within a defined uptrend and a Bull Market. But it’s definitely being tested and is going to have to prove its sustainability in the face of so many pressures. It’s not likely that an event like Monday is one and done. There’s more for the Market to dig through and excesses to unwind. A tsunami effect cannot be ruled out. The winds have definitely changed. We anticipate more swirling ahead, plus a few more quakes before smooth air is reached further out on the horizon. As always, when the facts change, we do too.
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Have a nice weekend. We’ll be back, dark and early on Monday.
Mike
