Market Update
Dear Friends & Clients,
While there is always a tremendous amount of “noise” in financial markets, it’s rare to truly be at an inflection point. After a myopic focus on inflation, and strident critiques that the Fed wasn’t doing enough to bring it down, investor concern has abruptly shifted to fears that the Fed won’t cut rates fast enough to get ahead of a slowing economy. Although not all economic slowdowns end in recession, all recessions begin with an economic slowdown. We don’t yet have enough data to say where the current trajectory will take us. While, in a global context, the U.S. is still on enviable economic footing, recent labor data suggests the Fed can no longer afford to complacently assume that a strong economy will give them enough slack to absorb policy missteps. Fortunately, corporate earnings remain strong, and the early August sell-off was concentrated in the most overvalued names. In short, after a relatively calm first half to the year, we anticipate the recent elevated volatility to continue until the market gains more confidence in the economy’s ability to weather the Fed’s tardiness in easing policy.
Below is a more detailed analysis of the some of the underlying market dynamics, and investor concerns.
Broken clocks and the “yeah, but” bears: given the legitimate concerns over a slowing economy, the “yeah, but” bears, who have been able to find the storm cloud behind every silver lining since the pandemic (despite the market’s success), are going to become much louder. Similarly to a broken clock, those with permanently pessimistic outlooks are right at least once every market cycle. Because loss aversion is about twice as powerful at motivating the average investor compared to greed, dour economic views are usually given more airtime2. We simply do not yet have enough data to know if the “soft landing” is going to continue to stick.
About trees growing to the sky: post-COVID, diversification and asset allocation haven’t worked particularly well. Moderate investors got hit almost as hard as aggressive investors in 2022 due to bonds having their worst year since 186010. Even a more conservative allocation within stocks didn’t work as anticipated, as dividend payers were rendered relatively less attractive, due to the high rates investors could suddenly get in cash and CDs. Outside of the Magnificent 7 growth stocks, very little forward progress has been made since 20221. So, it was hardly irrational for investors to concentrate so much capital in the 7 names trouncing everything else. Unfortunately, valuations can only become so stretched before something breaks. As is often the case in markets, things tend to happen all at once, or not at all, and, in early August, we saw the AI hype trade unwind violently with tech names dragging the S&P 500 down nearly 10% in 3 days. It was much uglier under the surface with the semiconductor index down around 25% from its highs less than a month prior7. Ultimately, we think it’s healthy that some of the AI hype premium has dissipated.
Sahm rule: invented by Claudia Sahm, the Sahm Rule has been one of the most accurate predictors of recession. Since 1970, it has coincided with every recession8. According to the St. Louis Fed, “The Sahm Rule identifies signals related to the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months.9” The Sahm rule triggered on Friday 8/2, which was another contributing factor to the market’s selloff. Acknowledging that 4 of the most dangerous words in investing are “it’s different this time,” it may very well be due to the fact that unemployment was too low at 3.4% and its recent rise could be more reflective of a “normalization” than deterioration.
So, what just happened in early August: the more liquidity in markets, the less volatile they are. If there’s extra cash waiting to be put to work, investors look for excuses to deploy capital and any “dip” gets bought faster. While the excess liquidity from the pandemic stimulus has been wrung out, popular during the “zero rate world”, the “carry trade” has provided a tremendous amount of liquidity over the last decade. Even when the Fed had the U.S. pegged at 0% interest rates, the 10-year US treasury still averaged a post 08’ yield of around 2%3. Meanwhile, the Japanese equivalent averaged a yield of around 0.5% (and is still under 1%)4. This led institutional investors to get cheap loans in Yen and then invest the proceeds in more productive areas. While the “carry trade” usually takes place between assets of equivalent risk, a huge amount of money from this cheap leverage went into stocks. With fears of a US slowdown and Japan’s central bank looking at raising rates, this trade unwound dramatically in early August, which contributed to the speed with which the market plummeted5. The market would have sold-off on the lackluster jobs data anyway, but coupled with a tide of liquidity rapidly receding, it produced the highest levels of market fear (VIX) since the pandemic6. The home of the carry trade (Japan) was particularly hard hit on 8/5 with the Nikkei 225 down over 12%6.
New Office: the new office is starting to feel like home and has been well received by those who have visited us! We did set the bar pretty low with our 3-year “temporary” space. Thank you for your patience while we found a more suitable home. For those of you who haven’t had an opportunity to drop in, we look forward to showing you around!
As always, don’t hesitate to give us a call if you would like to discuss anything in more detail!
Raymond James & Associates, Inc., member New York Stock Exchange/SIPC
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OUTSIDE RESEARCH
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ADDITIONAL DISCLOSURE
1: https://foolwealth.com/insights/sp500-and-the-magnificent-7-in-2024
2: https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/loss-aversion/
3: https://www.cnbc.com/quotes/US10Y
4: https://www.cnbc.com/quotes/JP10Y-JP
5: https://www.bloomberg.com/news/articles/2024-08-11/carry-trade-blowup-haunts-markets-rattled-by-rapid-fire-unwind
6: https://www.investopedia.com/stock-volatility-highest-since-covid-pandemic-vix-index-8690179
7: https://www.morningstar.com/etfs/xnas/soxx/chart
8: https://privatebank.jpmorgan.com/nam/en/insights/markets-and-investing/what-is-up-with-the-sahm-rule-and-what-does-it-mean-for-the-fed#:~:text=The%20Sahm%20Rule%20was%20meant,with%20every%20recession%20without%20failure.
