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If it were not enough that investors are digesting less-than-stellar second-quarter earnings, they are also dealing with the mixed seasonal patterns unique to August. August tends to be a mediocre month for stocks, with no strong directional bias. Some indices might see slight gains, while others could experience declines. This lack of a clear trend makes August a bit of a coin flip for investors.
It’s like picking a suitcase on the TV game show Deal or No Deal…never knowing what you will get. Not knowing can be half the fun or more likely half the frustration. This August is following the same seasonal pattern, despite some over-the-top intraday volatility.
To that point, we recognize that underpinning stock selection is the inability to predict emotional short-term responses to macro events. Affectionately referred to as the “Fire, Aim, Ready” axiom. Case in point, Aug. 5, when the Dow Jones Industrial Average fell more than 1,000 points within the first hour of trading.
Keeping with the fire, aim, ready truism, investors typically sold first without really knowing why. While there were three explanations for the selloff, the one fact that stood out to us was the SPX (S&P 500) closing price of 5,163.10 (the low point when stocks opened for trading on Aug. 5 of the day – see chart below). That closing value was approximately 10% below the most recent high, which is what we would expect to see in a normal correction. The market bounced off that level on Tuesday and held above the low point for the remainder of the week.
The challenge for investors is not related to the typical correction. It is more about the speed at which the correction took place. Experiencing a 10% correction in three to five days rather than over a period of one to two months takes a considerable emotional toll.
Because of that, we believe it is important to put some meat on this skeleton by shedding light on the three factors that caused the selloff. They include the trigger, which was the carry trade, the explanatory positioning, which was the unemployment report (notably the Sahm Rule), and the rotation shift, which was the macro momentum factor.
Imagine borrowing free money and using that capital to buy securities that provide a positive yield. Seems too good to be true, but it was this unusual set of events that supported the Yen carry trade.
Large institutional hedge funds began investing in this strategy in 2022, when inflation became a problem for most industrialized economies. Japan, with its unique demographic, being the exception.
As inflation spiked – except in Japan – central banks began raising interest rates to quell excess demand as households were flush with cash from pandemic-induced government stimulus.
The Bank of Japan was the outlier, holding interest rates at or near zero to combat stubborn deflationary influences that had gripped the economy. In fact, during the early stages of the carry trade Japan, was experiencing negative interest rates.
Hedge funds pounced on this aberration by borrowing Yen (i.e. to borrow Yen, funds would sell Japanese bonds) and using that free capital to buy positive-yielding assets like U.S. Treasuries, and for the managers looking for more aggressive exposure, buying the Magnificent Seven stocks.
Not surprisingly, since hedge funds are paid for performance, leverage was employed to pump up returns. The carry trade became so popular that at one point, analysts estimated that more than a trillion dollars was committed to the strategy.
That may seem like a big number, and it is, but foreign exchange and fixed-income markets represent the majority of available capital in the global sphere. The size and scale of these markets dwarf the global equity space.
The main risks in a carry trade are changes in the exchange rate and interest rate differential. If rates rise in Japan and the Yen appreciates against foreign currencies, it can eliminate the profit from the interest rate differential. Depending on the size of the move, it can reduce the gains or even turn them into losses.
A tsunami swept over the carry trade on July 31 when the Bank of Japan decided to raise interest rates to 0.25% from 0.10%. The Yen surged against the U.S. dollar, and Japanese bonds attracted a bid.
This caused an epic unwinding of the yen-funded carry trade that wreaked havoc across global markets. The strategy that had kept money flowing into global risk assets for years forced investors to abandon the trade as the yen surged higher. The Japanese equity markets had their worst day since 1987.
At the same time, U.S. bonds resetting based on expectations for a September rate cut, and U.S. equity investors were mired in a rotation out of the magnificent seven tech stocks into more value-oriented plays like consumer staples, healthcare, small cap stocks, and financials. This sea change triggered a rush to the exits, which we suspect caused the capitulation when stocks opened for trading on Aug. 5.
There may be more to come because the carry trade operates in an institutional space. Prices are set by reams of institutional traders who can buy sizeable blocks to assist with the unwinding process. The best guess is that 50% to 60% of the carry trade has been unwound. We suspect, at this stage, that most of the inherent leverage has been removed. If that assumption is correct, any further downside should be manageable.
The “Sahm Rule,” named after macroeconomist Claudia Sahm,1 is an economic indicator that attempts to highlight the preliminary stages of a recession. Ms. Sahm introduced the indicator as part of a policy proposal called “Direct Stimulus Payments to Individuals.” The proposal, published by The Hamilton Project,2 was to inject government stimulus into the economy at the onset of a recession. If the stimulus was injected at the right time, it could shorten the recession’s timeline and reduce the economic impact.
It was an interesting line of attack if you favor a liberal course of action. Unfortunately, or fortunately (depending on your political bent), liberal policies are a tough sell in the U.S. As such, government stimulus never gained much traction.
Still, the concept was grounded in logic. When analyzing the ex-post trajectory of recessions, economists noted that most began with a marked slowdown in consumer spending. Likely, as in the current environment, because inflation wreaked havoc on consumer’s disposable income. Not to mention angst – real or imagined – about a slowing jobs market.
Sahm believed that automatically injecting government stimulus payments to families at the onset of a recession would dramatically reduce the impact of higher unemployment that invariably accompanies a downturn. The challenge was trying to time the stimulus injection. Predicting the onset of a recession is like trying to predict the weather. There are simply too many variables that are subject to sudden changes.
The Sahm Rule was designed as a tool to predict the onset of a recession, which she defined as a point at which the three-month average national employment rate jumps at least half a percentage point relative to its low over the last 12 months.
What makes the Sahm Rule interesting is its simplicity and ability to quickly reflect the onset of a recession. According to the Sahm Rule, the early stage of a recession is signaled when the three-month moving average of the U.S. unemployment rate is half a percentage point or more above the lowest three-month moving average unemployment rate over the previous 12 months.
The unemployment rate represents the percentage of the overall labor force that is unemployed. The rate tends to rise when the economy is struggling, and workers are having difficulty finding jobs and falls when the economy is strong and workers can more easily find employment. The Bureau of Labor Statistics (BLS) typically releases the unemployment rate for the previous month on the first Friday of every month.
The Sahm rule compares the value of the current three-month moving average unemployment rate to the value of the lowest three-month moving average unemployment rate over the last 12 months. If the former is half a percentage point or more above the latter, the Sahm Rule indicates that the U.S. is in the initial stages of a recession. The Sahm Rule uses the three-month moving average unemployment rate – rather than the current unemployment rate – to prevent overreacting to a single month of data.
Since the early 1970s, the indicator has never been triggered outside of a recession, according to Sahm. Historically, when the unemployment rate passes the threshold outlined by the Sahm rule, it continues to increase. And we now come full circle. The Sahm rule was triggered, and investors reacted when the unemployment rate bumped higher on July 27 (see chart below). The rule has historically proven to be very accurate. Since the 1970s, the Sahm Rule has always triggered in the early stages of a recession.
Investors were concerned, because if we are at the beginning of a recession, it could put the soft-landing scenario in jeopardy. That may be true, but be mindful that the Sahm Rule has limitations. Most notably, as Sahm pointed out in her newsletter, the rule is “empirical regularity,” not a proposition. She emphasized that this means that the rule can issue a false narrative.
For example, Sahm wrote in an April 2022 newsletter, imagine a scenario in which the unemployment rate increased to, say, 3.5%, up from a low of 3.0%, meeting the criteria for signaling the early stages of a recession. However, if around that same time, GDP growth held around 2.5%, down from a high of 5.5%, and inflation gradually slid down to 2%, such a combination of circumstances probably would not constitute a recession, she explained.
The recent slowdown in the U.S. job market touched off days of global stock market turmoil, also fuelling speculation the Federal Reserve may not wait until its next scheduled meeting, in September, to cut interest rates.
Indeed, an interest rate futures contract expiring this month that tracks Fed policy expectations recently shot to a two-month high, implying that rates would be lower by the end of August.
Before the equity markets were spooked by the Sahm Rule and pummeled by the unwinding of the carry trade, traders were engaged in a rotation away from momentum stocks into more value plays and small-cap companies.
The backdrop for this rotation was the notion that the Federal Reserve would begin cutting interest rates sooner rather than later. Lower rates would make it more cost-effective for smaller companies, which would improve their profit margins.
Small-cap stocks had been underperforming their large-cap cousins since the end of the pandemic. Not surprising, since larger companies had sizeable balance sheets and were earning decent interest on their cash hoard. Moreover, adding leverage would only have a minimal impact on their earnings per share, so there was no urgency to borrow. Small-cap companies, on the other hand, needed capital to grow, which meant that higher rates hindered their bottom line.
The market rotation was most pronounced among the mega-cap technology stocks. Analysts viewed this as a positive development because the market had become so concentrated. Unfortunately, these transitions can lead to enhanced volatility.
Volatility spiked as the early shift away from momentum stocks combined with the triggering of the Sahm rule and the unwind of the carry trade. At one point, the CBOE Volatility Index crossed 60, which had not been seen since the onset of the pandemic.
In short, we are convinced that the Fed has a bias toward easing policy. Not surprisingly, given this view, Fed officials believe inflation is the result of various supply shortfalls in the economy, rather than demand fueled by factors like aggressive fiscal spending and excessive growth in the money supply.
According to Morgan Stanley, “This bias is now being tested and odds are rising that the Fed’s apparent objectives around financial liquidity and market stability will be exposed.” In this environment, portfolio diversification is key.
The advantage when confronted with a combination of cross-currents is that it provides an opportunity to rebalance portfolios, taking profits in richly-valued equities while adding some exposure to high-quality fixed income without much need to invest in longer-duration assets to find attractive yield.
Notes
1. Claudia Sahm worked at the U.S. Federal Reserve and served on the White House Council of Economic Advisors.
2. The Hamilton Project is a think tank at the Brookings Institution.
Richard Croft is Founder, Chief Investment Officer, and Portfolio Manager of R.N. Croft Financial Group Inc.
Disclaimers
Content © 2024 by R.N. Croft Financial Group Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. Used with permission.
Commissions, trailing commissions, management fees and expenses all may be associated with fund investments. Please read the simplified prospectus before investing. Investment funds are not guaranteed and are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer. There can be no assurances that the fund will be able to maintain its net asset value per security at a constant amount or that the full amount of your investment in the fund will be returned to you. Fund values change frequently, and past performance may not be repeated. The foregoing is for general information purposes only and is the opinion of the writer. No guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
R N Croft Financial Group Inc. is a Licensed Discretionary Portfolio Management and Investment Fund Management company serving investors and investment professionals across Canada since 1993.
Image: iStock.com/ra2studio
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