You have probably noticed the news pivot to the stock market lately. After a remarkably smooth ride throughout 2024 – the market ended the second quarter up 15% with the largest drawdown of only about 4.5% in April – volatility returned with a vengeance.[i] The last few weeks saw a 9% decline in the S&P 500 including Monday’s -3% swoon. Jarring for everyone – especially those who grew accustomed to the year’s smooth ride upwards.
There are technical reasons for the sell-off - the Yen carry trade blew up. I will try to keep from boring you here, but the carry trade involves borrowing low yielding currencies to buy a higher yielding currency. The Bank of Japan has kept local interest rates artificially low for a long time, so enterprising investors borrowed Yen at low rates and bought dollars or pesos or Australian dollars or whatever higher yielding currency and collected the spread. Borrow at 0.25%, lend at 5%, keep 4.75%. Or borrow at 0.25% and buy high flying U.S. tech stocks. This sort of trade works until something breaks. Last Sunday evening (Monday’s trading in Japan), the Bank of Japan announced they were raising interest rates; that is, something broke. Suddenly the Yen appreciates, and the carry traders receive margin calls. They sell other assets to meet the margin call and the market ends the day down 3%. Queue panic…
But all this talk of carry trades and FX markets and currencies is a bit extraneous. Market downturns all have a similar archetype. People like something, they buy it and the price goes up. Others see the price going up and decide they want to own it. They buy too and the price goes up further. Excited by the runup, people borrow money (leverage) to buy more. The price goes higher. Everyone is making money. Making money is fun, so they buy more with even more leverage. Then something bad happens and the price goes down. Levered investors get margin calls and have to sell the thing that used to be going up to repay their loans. The price goes down more. People who bought without leverage were accustomed to prices going up. Now they’re alarmed to see prices going down, so they sell. Prices fall further. The investors that really loaded up on leverage now face massive margin calls and must sell other assets to pay their debt. Those asset prices begin falling. And so on and so on.
In 2008 the assets everyone wanted to buy were derivatives tied to the real estate market – collateralized debt obligations, synthetic CDOs, and all sorts of esoteric derivatives Wall Street came up with to satisfy the insatiable demand of people willing to borrow to buy more of the thing that was going up. In 2021 it was tech stocks and cryptocurrencies and special purpose acquisition companies – the things people were willing to borrow money to buy more of. In 2024 investors were borrowing money to buy low yielding currencies to collect the spread on the carry trade. The BOJ raised interest rates, the carry trade unwound, levered traders got wiped out and had to sell other assets to meet margin calls, the prices of those assets decreased. Nothing is new under the sun.
The market downturn archetype:
Asset price increases → Demand increases → People buy more → Price increases → People borrow money to buy more → Price increases → Something happens and the price reverses → levered traders get wiped out and sell the asset and others to meet their margin calls → unlevered traders see price going down and sell → price goes down further…
There is an old quote that goes something like the stock market is a giant distraction from the business of investing.[ii] The point is the stock market has a lot of participants and you can’t see them. There are hedge funds, algorithms, pension funds, sovereign wealth funds, financial advisors, retired couples drawing an income from a portfolio built over an entire working lifetime, young professionals funding their first 401(k), sixteen-year-olds trading on their iPhone… Millions of different people and entities all with completely different objectives operating in the same market. So the last few days it seems the BOJ wiped out the traders trying to make a quick buck on the carry trade. If you have been borrowing Yen to buy higher yielded assets – or employed an advisor to do so on your behalf – you are probably in trouble. If you didn’t do that… then it’s all a big distraction. Unfortunately, people respond to distractions. They will see their 401(k) drop suddenly, have their fears confirmed by whichever news media they turn to – who will undoubtedly assure them catastrophe is brewing – and find solace in selling some or all their portfolio. All because someone – with a different set of objectives – took too much risk borrowing currency in Japan.
As of this writing on August 7th, we do not know whether this downturn will continue or reverse in the short term. We recommend running from anyone telling you they know what the next weeks and months hold. We can provide some historical context for this decline – since 1928, 94% of years have seen a decline of greater than 5%.[iii]The strange thing about the first two quarters of this year was that there hadn’t yet been a 5+% decline. Additionally, the average intrayear drawdown since 1980 is -14%. Here you’ll see each year since 1980’s annual S&P 500 return (grey bar) charted alongside the year’s largest intrayear decline (note this chart ends at the halfway point of 2024):[iv]
We hope you find the financial media/social media/internet/blogosphere’s recent panicked response to a 9% decline instructive in the context of the above chart.
Again, we do no know how things will end up this year or next. But we do know how the archetype plays out. Eventually prices fall to a point where buyers see bargains and start buying. Stock prices go up. Companies report better than expected earnings. People buy more. Prices appreciate. Companies innovate and report even more profits. Prices go up. People buy more. Companies return capital to shareholders via buybacks or dividends. People buy more. Prices appreciate.
There is nothing new under the sun. Don’t let the stock market distract you from the business of investing.
Sean Cawley, CFP®
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Content here is for illustrative and educational purposes only. It is not legal, tax, or individualized financial advice; nor is it a recommendation to buy, sell, or hold any specific security, or engage in any specific trading strategy. Results will vary. Past performance is no indication of future results or success. Market conditions change continuously.
This commentary reflects the personal opinions, viewpoints, and analyses of Resolute Wealth Management. It does not necessarily represent those of RFG Advisory, clients, or employees. This commentary should be regarded as a description of advisory services provided by Resolute Wealth Management or RFG Advisory, or performance returns of any client. The views reflected in the commentary are subject to change at any time without notice.
[i] YCharts, Fundamental Charts, ^SPX, 01/01/2024 – 06/30/2024.
[ii] I believe Jack Bogle said this.
[iii]https://awealthofcommonsense.com/2024/08/this-is-normal-2/
[iv] JPM Morgan, Guide to Markets, 3Q 2024.