Amid higher volatility, stay focused on the long run

1) The stock market had one of its most volatile days ever yesterday...

At one point yesterday, the CBOE Volatility Index ("VIX") – which is often called the market's "fear gauge" – nearly tripled (in a single day!) and closed a whopping 65% higher than Friday.

As this tongue-in-cheek post on X yesterday notes, the only comparable days were during the global financial crisis and the COVID-19 crash:

The S&P 500 Index fell as much as 4.3% yesterday and finished the day with a 3% loss.

2) A range of factors contributed to the chaos (as the late Charlie Munger explained, extreme occurrences – both good and bad – are rarely caused by one thing... rather, they are almost always the result of what he called "lollapalooza effects")...

Last week's economic report showed strong 2.8% GDP growth – up from 1.4% in the first quarter – but the U.S. economy added only 114,000 jobs in July. That was significantly below expectations, and the unemployment rate increased to 4.3%.

Additionally, the Global Manufacturing Purchasing Managers' Index fell to 49.7 in July from 50.8 in June – indicating a contraction in global manufacturing activity for the first time in seven months.

All this raised investors' concerns that the U.S. economy is slowing – raising fears of a hard landing instead of a soft one.

Meanwhile, the Bank of Japan's decision last week to raise interest rates for only the second time in two decades (albeit to only 0.25%) surprised investors and triggered a frantic unwinding of a popular, leveraged "carry trade"...

A carry trade is when an investor borrows money from a country with low rates and a weak currency – such as Japan and the Japanese yen – and then invests that money in assets of another country with a higher rate of return – such as Mexico and the peso.

However, if the weak currency suddenly strengthens, as the yen has done in the past month, surging from 162 to the dollar to 145 today – a stunning move in a market usually measured in pennies – it can trigger huge dislocations.

This carry trade was a classic case of "picking up pennies in front of a steamroller" – a phrase describing investments in which there are small, steady profits... but also the risk of catastrophic losses. (For other examples of this – and how they often blow up – see my e-mails from June 4 and January 20, 2023.)

The major Japanese stock index, the Nikkei 225, plunged 12.4% yesterday, after falling 5.8% on Friday – its worst two-day performance in history. It's down 25.8% from the all-time high it hit less than a month ago.

Now, you might be wondering why events in Japan are causing turmoil here. Bloomberg columnist Matt Levine explained it well in his column yesterday: The Good Trades Have Gone Bad. Excerpt:

Market crashes usually have the same mechanism. People like a thing, so they buy it, so it goes up. More people like it, so they buy more of it, so it goes up more. It goes up steadily enough that people think "ehh I should borrow some money to buy even more of this thing," so they do. Eventually a lot of very leveraged investors own a lot of the thing.

Then something goes wrong with the thing, its price goes down, the leveraged investors get margin calls, and they have to sell the thing to pay back their loans. Their losses are big enough that they have to sell other things, things that were fine, to pay back their loans on the thing that went wrong.

The big leveraged investors who owned a lot of the thing that went wrong also all own the same other things, also with leverage, so there is a generalized crash in the prices of the things that big leveraged investors own.

I suspect that the "big leveraged investors" Levine refers to, who got caught with their pants down on the yen carry trade, are also long the tech- and AI-related stocks that have been driving the market... and hence we're seeing spillover effects.

I'll also note that the markets have been unusually tranquil, which breeds complacency and excess leverage.

In a post on X yesterday, Ben Carlson – who writes the popular financial blog "A Wealth of Common Sense" – shared this clever chart showing that a 2% daily move in the S&P 500, which used to be commonplace, had been rare:

3) My regular readers shouldn't have been surprised by the weaker economic numbers...

In my e-mail exactly a week ago, I opened it by writing: "A number of data points over the past week have convinced me that the U.S. economy is slowing."

In particular, I quoted two of my friends for more insight...

The first – an investor in many private companies across the country – told me that "the economy is rolling over. Our really good businesses are doing fine, but many of the others are in real trouble."

The second friend runs a wholesale distribution business that serves thousands of customers that, in turn, directly serve millions of Americans all over the country every day.

As I explained in his case:

He told me that there's definitely a slowdown – for example, he's now seeing his customers' businesses down 8% year over year in recent months, except for a few that are executing superbly and/or serving high-income customers...

Overall, my friend's customers are "worried and scared."

That said, I also mentioned that neither of these two friends were predicting a big recession... and nor was I.

As I concluded:

So my general message to investors is: If you own the stocks of quality companies or index funds and have a long-term (at least three years and ideally five or more) investment horizon, don't do anything.

But if you're overinvested in stocks – let's say your portfolio is 90% stocks and it really should be 75% – or are hanging on to some stocks in which you have low conviction, it's probably not a bad idea to trim a little bit.

4) So after the recent turmoil, has my advice changed?

In a word, no.

The economic fundamentals haven't changed – and remain solid. Yes, the economy is slowing... but as I wrote a week ago, "keep in mind that this softness is coming after the economy was white-hot, which the Federal Reserve deliberately cooled by raising rates rapidly to bring down inflation."

And inflation remains muted. In the July 11 report for June, month-over-month prices declined 0.1% – the first monthly decline since May 2020. And the core price index, which excludes volatile prices of food and energy, increased 3.3% year over year – the lowest yearly increase since April 2021.

The comparisons to the global financial crisis and the COVID crash are ridiculous. It's more like 1987, as this Wall Street Journal article from yesterday notes: Is This 1987 All Over Again? What's Driving the Market Meltdown? Excerpt:

The S&P made 36% in the eight months to its August 1987 peak, similar to the 33% it rose in the eight months to the end of June this year. As in 1987, this year's gains came in spite of tight monetary policy and higher bond yields. Just like today, in 1987 investors were on edge and ready to sell to lock in the unexpected profit.

The losses are smaller so far, but lucrative trades have reversed, just as they did for the market as a whole in 1987.

Needless to say, anytime in 1987 – even on the eve of the infamous Black Monday crash on October 19, when the Dow Jones Industrial Average fell 22.6% – would have been a great time to invest.

The S&P rose 16.6% in 1988, another 31.7% in 1989, and has kept on chugging, as you can see in this chart of the value of $100 invested on January 1, 1987 (I've circled the Black Monday crash, which is barely detectible):

What happened yesterday is simply a reminder that stocks can be volatile.

As the table below from a recent post on X from Creative Planning's Charlie Bilello shows, this is the S&P 500's 29th decline of 5% or more from its highs amid the massive overall run higher since March 2009:

I tend to agree with betting site Polymarket, which as of earlier this morning shows only a 15% chance of a recession this year and a 92% chance that the Fed will cut rates (a 50% chance for a cut of 0.5% and a 42% chance for a cut of 0.25%) at its September meeting (but only a 18% chance of an emergency rate cut this year).

In summary, I of course can't say for sure what the market will do in the coming days and weeks. But I think it will soon recover, as it has done the past 28 times before this current dip... So tune out the short-term gyrations and keep focusing on the long run.

Best regards,

Whitney

P.S. I welcome your feedback – send me an e-mail by clicking here.