Here's Some Advice You Never Follow: Pay Attention To Crowds
Making sense of a shift in the markets
Stand Back: Watch and Wait
Markets will drive you crazy if you let them. The goal is to stay sane amid the tumult. I’m going to help you with that.
This article is last week’s this week (but probably this week’s, too…).
In summary,
The market moves were not due primarily to the jobs numbers.
The Federal Reserve is not going to cut rates until September.
They will probably cut by 50bps.
Stocks will continue fluctuating - use peaks to sell and rebalance and dips to buy.
Know what you own and why.
T-bills will stop being so attractive, so think about longer-term, between 2-10 years.
Don’t worry about Warren Buffet selling half his Apple stake. It was too large (22% of Berkshire’s market capitalization), and he still owns $84B.
Volatility will continue.
Crowds are never your friend. Crowded trades involve too many people who have already figured it out.
“Sale on money” will attract a crowd. However, the supply will likely be exhausted by the time you arrive.
I love this chart and the following one because they illustrate how psychology can obscure what is actually happening.
Everyone who dispenses market commentary except me (see 1-8 above) will predict what will happen to markets in the future but tell you there is no guarantee of timing.
Great. If you are playing golf this afternoon, “rain sometime in the future” is not useful as a forecast.
What is Volatility?
Volatility is the price we pay for long-term gains.
When the markets talk about volatility, they are referring to a specific index, the VIX, that is calculated by the CBOE (Chicago Board of Exchange).
The formula examines the trading in short-term put and call options on the S&P 500 Index. The prices and volumes of these options allow the calculation of the VIX.
The VIX has long been at historically low levels. Although it is usually said that bull markets climb a wall of worry and that the time to worry is when no one is worried anymore, the VIX has not been showing a high level of worry.
The above chart shows what happened starting on Friday, August 2: VIX doubled.
On Monday, it shot up to nearly double again.
What Happened on Friday?
On Friday, the US Department of Labor’s Bureau of Labor Statistics (BLS) published jobs data indicating that the US economy added 114,000 jobs in July—less than the expected 175,000.
There were also downward revisions for April and May, totaling 111,000 jobs.
Earlier in the week, the Federal Open Market Committee Meeting (FOMC), while hinting that conditions were moving toward the committee being more inclined to lower the Fed Funds at its September meeting, there would be no cut before then.
Then, the crowd took over: volatility rose, and stocks fell. We were treated to the following:
A friend who sells and trades short-term T-bills told me Saturday that if the Fed ‘had any balls,’ they would cut 50 bps on Monday. This is full panic. This is a full tantrum.
I posted a video saying the article I had planned for Friday would be delayed to allow things to unfold.
Look at the S&P 500 charts for 5 days, YTD, and 1 year.
Red charts are never fun to look at. Green charts are comforting and meet our need for things generally going up and to the right.
Green charts generally mean VIX is low. Red, the opposite. Liz Warren has nothing to say about green charts (except maybe “tax the rich because they are getting richer”) but a lot to say about the last five days.
What Else Happened on Friday?
The Sahm Rule was triggered.
Claudia Sahm is a highly credentialed macroeconomist. Among her impressive career milestones, she worked at the Federal Reserve and the Council of Economic Advisors during the Obama Administration.
In 2019, she contributed to a paper published by the Brookings Institute, writing a chapter about certain stabilizers that could be used at the front end of a recession to get stimulus checks into the hands of citizens to ward off the ill effects of a recession.
The measures were intended to be triggered by a heuristic (rule of thumb) that said when the unemployment rate measured by the last three months moving average was above the lowest such number for the past twelve months, we were in the early months of a recession.
Sahm herself said she had created a monster and, in a recent interview with Adam Taggart of Thoughtful Money, thought the volume had been turned too loud on the Sahm Rule.
In the same interview, she said she would never encourage the rule to be used to trigger a change in monetary policy because monetary policy, as opposed to fiscal policy, operates on a lag.
Remember, last Friday, the crowd called for a cut because the rule had been triggered.
And What Really Happened?
The jobs data were part of the story. The other, perhaps more significant part, was that the Bank of Japan (BOJ) raised rates from 0.1% to 0.25% on July 31.
Why did it do that?
Inflation had been running above the target of 2%: in May, it had risen to 2.5% from 2.2% in the previous month.
The yen had been depreciating for a while, thereby increasing prices. The prices of gas and oil were particularly concerning.
Earlier in the year, it had agreed to generous pay rises for a substantial part of the Japanese workforce.
The increase came as a surprise and created some panic among those - mostly hedge funds - who had been using the so-called Yen carry trade to fund their purchases of various risk assets.
The Yen carry trade is superbly explained by a money manager I love (I may have to put some money with him) called Lance Roberts.
A hedge fund sells short $10 million in Japanese Government Bonds that yield zero percent. (The hedge fund sold an asset they didn’t own, netting the fund $10 million and effectively shorting the Japanese Yen.)
The hedge fund then buys $10 million in U.S. Treasuries, yielding 4%, capturing the spread between the bonds.
Then, the hedge fund leverages that $10 million into $100 million (10x leverage) to buy risk assets.
Roberts continues:
“Now, consider that “yen carry traders” have leveraged highly volatile risk assets like cryptocurrencies, small-cap stocks, mega-cap stocks, and even the Japanese market. The carry trade works well as long as the Japanese Yen does not markedly appreciate, forcing a liquidation of the market leverage.
The problem, as shown below, is that the Yen has appreciated more than 15% in the last few weeks. As the Yen appreciates, the Japanese banks demand margin calls (i.e., the catalyst). When that occurs, the hedge funds, pension funds, insurance companies, or investors using the “Yen carry trade” must either put up more collateral or sell the leveraged assets. That reversal and forced liquidation created a vicious spiral by pushing the Yen higher and risk assets lower.”
So, as hedge funds unwound their trades and the selling, on a large scale, hit the market, stocks reacted down.
Roberts’ advice and mine: “Do nothing."
I recommend clicking the link to Robert’s article. It is very helpful in understanding the market dynamics.
Both he and I, though cautioning against this being investment advice, believe that following the crowd is not wise, and neither is paying attention to Elizabeth Warren.
Takeaways
The market moves were not due primarily to the jobs numbers.
The Federal Reserve is not going to cut rates until September.
They will probably cut by 50bps.
Stocks will continue fluctuating - use peaks to sell and rebalance and dips to buy.
Know what you own and why.
T-bills will stop being so attractive, so think about longer-term, between 2-10 years.
Don’t worry about Warren Buffet selling half his Apple stake. It was too large, and he still owns $84B.
Volatility will continue.
Never pay attention to crowds or politicians - they have no wisdom to shed on market movements.
Choose your advisors carefully.
Start by subscribing to Claudia Sahm’s substack and Real Investment Advice.
It’s funny how a single headline or news story can send people into panic mode when it comes to investing.
The best skills to master before investing in anything are research and patience.