By Mike Dickson, Ph.D.
The S&P 500 fell 3% on Monday—its biggest 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.
We don’t think that’s the case.
The reason: Nothing has significantly changed when it comes to key economic fundamentals that underpin the stock market.
In the most recent major economic data point – the July jobs report – hiring was slightly weaker than expected. The July report fell short of expectations, but 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 what we saw in April. Bigger picture, these deviations are normal and suggest 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 did so many investors stampede 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 exactly the wrong time: during the illiquidity of late summer. Examples of these positions include:
- NASDAQ vs Small-caps: The recent massive reversal in small-caps versus the tech-heavy NASDAQ 100, set in motion by the softer CPI print on July 11, was the first shock to market participants. Investors rushed away from the safety of the mega-caps in favor of cyclically sensitive sectors that benefit from lower rates, such as regional banks. And as 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 equity 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 rather 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 very weak 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.
- Equity 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 equity volatility trades led to the largest single daily spike in the VIX on record.
The upshot: These examples are a sign to us that positioning got too offsides over the last few months. When certain conditions change, this can cause the types of violent price movements we’ve seen lately.
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.
- An anticipated September start to interest rate cuts by the Fed should finally provide some relief through the rate channel.
With that in mind, we are calmly keeping our focus on the underlying fundamentals that drive businesses’ financial results and performance and on continuing to execute our goals-based investment strategies.
Originally published August 6, 2024
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