What's Behind Last Week's Stock Market Drama

This Monday was one of the worst days for global stock markets in years, Stocks in the US, Europe and Japan tanked on Friday and again on Monday before a partial rebound. Bond yields and foreign exchange rates swung around wildly too.

The Magnificent seven stocks lost about $1 trillion dollars in value in just two days. So, what exactly is going on in markets, and how much should we worry?

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Transcript

This Monday was one of the worst days for global stock markets in years, Stocks in the US, Europe and Japan tanked on Friday and again on Monday before a partial rebound. Bond yields and foreign exchange rates swung around wildly too. The VIX index, a measure of expected US stock market volatility rocketed to its highest level since the pandemic meltdown in early 2020. The VIX essentially tracks how expensive stock options are and can be seen as a measure of how worried investors are about large market moves in the near future (either up or down).  It had been sitting at around 12 for most of the year – which was quite low and implied that investors expected calm - before rocketing to 65 on Monday.  It has since returned to a more moderate 22.
Japan – which we have talked about quite a lot here over the last year was at the center of the storm.  The Topix index fell 12.2% on Monday, having hit an all-time high just three weeks earlier. The sell off wiped out its entire year to date gains. The press described it as the worst Japanese market crash since 1987 (something we will come back to in just a moment). The index rebounded 9 per cent the next day prompting the FT to describe it as “Trading like a penny stock.” which is not what you want to hear about the third largest economy in the world.
US markets, which had been strong all year fell almost 8% from their recent highs and the tech heavy Nasdaq fell almost 13% over the first three trading days of the month.
The Magnificent seven stocks – a term coined by Michael Hartnett at Bank of America about a year ago to describe the hottest tech stocks that retail investors are most focused on, lost about $1 trillion dollars in just two days. So, what exactly is going on in markets, and how much should we worry?
Well as always in markets there is never a quick and easy explanation, but the spark that lit the explosions in all of the YouTube finance thumbnails this week was last Friday’s US jobs report, which showed a much sharper slowdown in hiring than Wall Street expected.
For a spark to turn into a fire, you need some fuel and there was plenty of dry fuel lying around.  The ISM survey of manufacturing businesses from the day before had shown that industry economic activity had contracted at a faster rate than the prior month, and this was the fourth contraction in a row. There had been a few soft earnings releases too, for example at Microsoft, cloud services growth had slowed slightly to 29 per cent year on year, down from 31 per cent in the previous quarter.  That doesn’t sound like a big deal – except if these stocks are priced for perfection.
Apples revenue growth appears to be stagnating too, and its management are now pinning their hopes on AI (much like all of the others), which investors hope will revive growth. But so far, it’s hard to know how that might work.  According to Bloomberg if AI fails to pay off, Apple starts to look more like Coca Cola than high growth tech company.
Markets which had been pricing in a guaranteed soft landing (meaning an end to inflation without a recession) and really no political risk as I discussed in the recent Trump Trade video suddenly started assigning some probability to a hard landing. Goldman Sachs said over the weekend that it now believed there was a twenty five percent chance of the US falling into recession in the next year, compared with its previous forecast of a 15 per cent chance.
The recent rise in the stock market has been very much driven by the US consumer – and consumer strength is a function of the labor market.  Other evidence of a consumer slowdown can be seen in the earnings reports from Disney Airbnb and Hilton, all of whom are seeing lower demand.
While US inflation has cooled – meaning that prices are no longer rising – the consumer is still dealing with higher prices. According to the San Francisco Federal Reserve – Households have now spent the excess savings that they had accumulated during the pandemic.
As investors internalized the fact that six of the last seven major US labor releases had been disappointments, they started to question stock market valuations.
Because of time zone differences, The Japanese market was closed for a big part of the US sell off on Friday.  Part of the decline in the Japanese market can be attributed to just catching up with the US market – as the US market tends to drag other markets around with it, but Japanese investors were slowly digesting the surprise 25 basis point interest rate hike that had been announced the prior Wednesday and they began to panic when their market opened on Monday.  A big move in one market can lead to big moves in other markets because of interconnectedness and the way institutional risk management works.
The 25-basis point hike in Japanese interest rates doesn’t sound like a big move, but it was a surprise announcement, and it is the highest interest rate seen in Japan since 2008. Policymakers also announced that they would be halving monthly bond purchases and hinted that there would be more rate hikes in the pipeline. This was a big change.
Japanese stocks had hit new highs over the summer, and the Yen had been in a long-term downtrend, which was starting to cause problems. By July, the Yen was the weakest it had been against the dollar in 34 years.  This wasn’t a strong dollar issue either, it was weak against every other developed market currency too. While Japanese policymakers wanted inflation – they were worrying that the weak yen was causing the wrong sort of inflation – where imported goods were getting expensive, rather than Japanese goods and services. This meant that money would just leave Japan and do nothing to boost the local economy. The policy makers are aiming to spur inflation, which would be good for Japanese businesses who would then be forced to increase wages leading to a virtuous cycle where Japanese workers earn more and spend more – kickstarting the economy.
Japan’s core inflation rate had been above the Bank’s 2% target for 27 months and there was concern that the decline in the yen was just hurting consumer spending. The FT reports that Japanese government officials had put pressure on the Bank of Japan to hike rates and arrest the yen’s decline.
The interest rate hike on the 31st of July did have an impact.  The Yen strengthened quickly and on Thursday and Friday the stock market sold off - with Toyota, Panasonic and Japan’s biggest banks being the biggest losers.
Toyota had just reported record profits, boosted by a favorable exchange rate and increased consumer interest in hybrid vehicles rather than pure electric vehicles. The weak yen, which boosts the value of overseas profits for Japanese exporters, also helped. It’s price decline added two and a half billion dollars in operating profit to the firm over the quarter. The problem with that is that if the yen were to strengthen – like it did - the opposite would happen.
Over the last three years, the yen carry trade — which involves borrowing at a low interest rate in Japan to fund investment in assets elsewhere that offer higher returns — has exploded because of Japan’s ultra-low rates which contrast with higher interest rates around the world.  With the carry trade you can buy foreign bonds to earn the interest rate differential, or you can buy other risk assets.  This is a trade that works as long as the foreign exchange rate doesn’t move and wipe out all of your profits, or even cause you losses.
Low rates in Japan combined with higher rates around the world - especially in recent years - as central banks have been hiking rates to fight inflation caused this trade to explode in popularity.  It’s not just forex speculators who do this either, big Japanese companies often keep their foreign earned income abroad to reap the higher interest rates available.
The low-return environment in Japan over the last thirty five years led the Japanese into being amongst the biggest capital exporters in the world: they own over a trillion dollars of US Treasuries and half a trillion Euro bonds.
Commerzbank estimates that Japanese international investments come to around four trillion dollars in total.
The rapid appreciation of the yen brought about by the rate hike forced hedge funds and other leveraged investors to rapidly unwind their carry trades. This was a big contributor to the extreme volatility in global markets over the last ten days or so as investors rushed to dump assets, they had purchased by borrowing in yen.
The way risk management often works at big financial institutions is that when a big loss occurs in one investment strategy, the risk management team often walk around the trading floor telling traders who are running completely different strategies to cut their position sizes.  As these traders cut their position sizes, the spreads that they are trading widen, causing further losses, and further cuts in risk.  This can lead to contagion, and experienced traders who hear about a loss on a different trading desk often cut their positions right away – as it is better to get out quickly before the spreads start widening due to industrywide deleveraging.
We saw a huge spike in stock market correlation on Monday – correlation being a measure of the degree to which stocks move up or down together - as shares across the market fell in lockstep. This was a big change as in July correlation had hit a record low, helping to dampen overall market volatility.
I’ve made a few videos about Japanese markets over the last year or two and still feel that the Japanese market might be the most interesting thing going on in markets right now.
My first video on the rise and fall of Japan was made after finding a 1988 article George Soros had written in the wake of the 1987 crash.  In it he argued that the crash had signaled a transfer of financial and economic power in the world economy from the United States to Japan.
In the crash, Japanese stocks fell around 15%, which was much less than the 23 percent decline in the United States. On top of that, the Japanese market recovered to its pre-crash levels in just five months. While the US, UK and Germany all needed more than a year to achieve the same level of recovery.
The Japanese market appeared to do better as the ministry of finance pushed the nations four largest securities firms to start buying stocks to keep the market afloat. Japan was able to keep all of their balls in the air for a few years longer, but since 1990 the nation has been in decline.
In 1989, 32 of the 50 largest companies in the world were Japanese and Japan’s stock market was worth 45% of the whole global market, while the US was at 33%. Today, Japanese stocks are 5.4% of the global market and only one Japanese company (Toyota) is in the global top 100.
Japan has been struggling to recover from the malinvestment brought about by excessive government interference in markets for thirty-five years.  Today, western politicians look to Chinas economic miracle driven (once again) by government interference and wonder if they should mimic the industrial policies that appear to be generating all of this growth.
Japan’s public debt reached $9.2 trillion dollars as of March 2023 and at 263 percent of GDP is the highest debt to GDP ratio in the developed world - more than twice the debt to GDP ratio of the United States. Servicing this debt is already a struggle and will become more difficult if rates rise and the yield-curve control program is abandoned.
Japanese stocks broke a number of records last week — their combined 20 per cent fall over the three sessions from last Thursday to Monday was the biggest drop ever, wiping  $1.1trillion dollars off the value of the stock market. On Tuesday, the stock market bounced back by almost 10 per cent in the steepest rally in almost 16 years.
The Yen did seem very cheap at its lows, but the Japanese economy did contract in the first quarter of this year – so while the rate hike may have helped the yen, the Bank of Japan is hiking rates into a weak economy.
The severity of the market reaction is likely to have surprised the central bankers, but even after the decline the Topix is still up 4.4% year to date and up 65% over the last five years.
Pressure on the Yen can be expected to wane if the US starts cutting rates as the market now expects. interest rate differential will become less extreme under that scenario.
The reason the Japanese market is so interesting is that Japan is on a completely different economic cycle to the rest of the world, trying to spur inflation when the rest of the world was fighting inflation, and now hiking rates when the rest of the world is either cutting rates or thinking about it.
For the last year, Japan has looked like it might finally return to economic growth. But, over the past 30 years Japan has seen many false dawns, and the country is facing some big structural problems that won’t go away – their ageing population, low growth and high public debt.
Over the last few days, the S&P500 all but erased the losses suffered by investors in a week that included some of the worst and best days for US stocks in almost two years. The jobs report, added to fears that higher interest rates were finally having an impact and slowing the economy reducing companies hiring and consumers willingness to spend.  This is only so much of a surprise, as that is the mechanism through which higher interest rates reduce inflation, and it is not a bad thing for investors to be considering the risks when investing.
Blaming the carry trade unwind on the declines in the US stock market might be unreasonable, as the carry trade was by no means what was driving the rise in the US stock market over the last few years.
The worry with US stocks is that the magnificent seven - which have been driving stock market returns for quite some time - are failing to deliver on the sky high expectations that investors have for them. The magnificent seven had contributed 52% of the Year-to-Date return of the S&P 500 through to the end of July.  If you excluded Tesla from that group – as it has been falling for close to three years – the contribution of the remaining six stocks to US investors returns has been even higher.
As I mentioned in last week’s video, the big tech firms have been laying off staff for quite some time and more worryingly – insiders have been selling their stock. Indicating that they are possibly less excited about the AI future than the rest of the market is.
Leadership at Amazon, Meta, Alphabet, Nvidia Apple Microsoft and Tesla have all been selling.
Last weekend we learned that Warren Buffets Berkshire Hathaway had sold 390 million shares of Apple – which was about half of its stake.  Buffet started paring his position last year but really stepped up his sales in 2024.
The antitrust judgement against Google – finding that they have a monopoly in search came out on Monday, this wasn’t just bad for Alphabet – but also for Apple as court documents showed that Google paid Apple $20bn in 2022 alone, a huge chunk of Apple’s services business, which includes its App Store and Apple Pay.
If Alphabet is no longer allowed to pay apple to be the default search engine on their devices, Apple might leave the choice to customers – like they do in Europe – where most customers pick google – but Apple will receive no payment.
Earnings for the big US tech firms have not been bad at all. For example, if you look at Alphabets core businesses they have been doing just fine. But Alphabet (just like the others) is spending a fortune on AI which is not yet making money – and there is no obvious path towards profitability either.  This is the case for all of the big tech firms other than Tesla who have just been having a bad year as demand for their cars has dried up.
It is not yet obvious how the big tech firms plan to make back the money they are spending on AI and interestingly, a recent study from Washington State University found that including the term "artificial intelligence" in a product description made consumers significantly less likely to buy a product. So not only is there no clear path towards monetization, customers are possibly steering clear of AI branded products.
MIT researchers argued in a recent report that the types of AI being developed at the big tech firms is not designed to solve the kind of complex problems that would justify the costs, and the costs may not decline as many expect.
Big tech has been a crowded trade for quite some time and investors have made a fortune owning these stocks, but they are possibly getting a bit nervous.
An other big story during the big sell off on Monday was that brokerages like Charles Schwab, Vanguard and Fidelity experienced outages on their trading platforms, leaving some retail investors unable to trade on Monday. This is somewhat reminiscent of the brokerage outages that occurred during the meme stock frenzy a few years ago, and indicates how excited investors got over the market drama,
During the market sell-off on Monday, the treasury yield curve, which has been inverted for two years briefly returned to normal. An inverted yield curve — where two-year interest rates rise above 10-year interest rates — is said to signal that a recession is on the way. An inverted yield curve has probably predicted twenty of the last seven recessions.
Anxieties prompted by the bad jobs number were also heightened by the fact that the data release triggered what is known as the Sahm rule, devised by and named after the economist Claudia Sahm.
The purpose of the rule is to act as an early warning signal of recession. Claudia Sahn came up with the rule in early 2019 to act as an automatic trigger for policymakers to step in.
The way it works, according to its creator, is that when the three-month average of the US unemployment rate is half of a percent or more above its low of the prior 12 months, the US is already in a recession. This rule back tests well, but Claudia Sahn warned earlier this week on Bloomberg that as any investment prospectus will tell you: Past performance is no indication of future results.
Some economists have argued that some of the surge in the recent unemployment number reflected a temporary Hurricane Beryl effect as power outages on the gulf coast led many businesses to stay closed and temporary workers to sign on for unemployment.
Matthew Klein pointed out on his blog that while the job market may not be great, it is better than it first appears.  He points out that economic downturns normally feature large increases in the number of workers who lose their jobs and don’t expect to be rehired. These “permanent” job losses are quite distinct from situations where people enter the labor force but don’t immediately find a job, or when people are temporarily laid off but expect to be rehired shortly, there are also people who finish temporary jobs, and “job leavers” who quit without immediately finding another job.
He says that bad labor markets also feature large increases in the number of workers who lose their jobs and stop actively looking for work. This group are not counted as unemployed, but they are counted as people outside the labor force who “want a job now”.
He highlights that the recent increase in the unemployment rate is almost entirely attributable to the categories of joblessness that are least representative of bad underlying economic conditions.
Claudia Sahm also wrote on Bloomberg that there are signs that stronger labor supply, not just weaker labor demand, helped push the Sahm rule past its half a percent threshold. Unemployed entrants to the labor force (new or returning) accounted for about half of the increase which is a notably higher share than in recent recessions, when most of the contribution came from unemployed workers who had been laid off temporarily or permanently. She says that the current Sahm rule reading is likely overstating the weakening in demand and is not at recessionary levels. She does argue however that the federal reserve should be thinking about cutting rates.
It has been quite an interesting week in markets, with many wondering if we are in a period of regime change. Rate increases are supposed to slow the economy as that is how they reduce demand for goods and bring down inflation, and that is exactly what they are doing. The higher rates have by no means eliminated risk taking, as evidenced by the fact that meme stocks and crypto are still riding high.
One way higher rates slow the economy is by weakening the job market – last weeks video on Tech layoffs looked at how low interest rates can lead to moonshot projects, but when rates go up, investors start expecting to see a return on their capital, and they begin to care about the timing of the cashflows.
Real US GDP grew at an annual rate of 2.8 percent in the second quarter of 2024, so it’s not like economy is doing badly and most global equity markets have reversed the majority of Monday’s losses.  Volatility is higher than before, and a lot of big earnings numbers still have to come out.  A big signal of the health of the US tech sector will be the Nvidia earnings report at the end of this month.
One of the big lessons of the week is that it usually doesn’t pay to panic in a sell off.  The brokerage website outages on Monday likely saved a few panicked investors some money if they were trying to sell near the lows.
Thanks for tuning in to this week’s podcast which is entirely supported by users like you on Patreon – there is a link to that in the show notes if you want to contribute.  Have a great week and talk to you again in the next podcast, bye.