Hello Volatility!

Wow! That was one hell of a week last week!

As you know, the stock market peaked in early July after a constructive inflation report showed inflation under control. That report gave investors confidence that the Federal Reserve could move forward with lowering interest rates.

Initially, this helped all stocks. Below are charts of the market-cap weighted S&P 500 Index (SPX) and the equal-weighted S&P 500 (SPW)…

We have put a line on those charts showing where these indices began the year.

One criticism of the stock market in 2024 has been that a relatively small number of stocks has led it. About a dozen stocks drove most of the return of the market-cap-weighted S&P 500.

You can see this by looking at how much higher that index was relative to where it started the year. This leadership also led that index quite far from its 50-day moving average for most of the year.

After the subdued inflation, though, something began to change.

We saw a rotation OUT of those largest companies and INTO the rest.

You can see that in the charts, as the market-cap-weighted S&P 500 peaked on July 16 and was -3 % lower by the end of the month. Meanwhile, the equal-weighted S&P 500 hit an intraday ALL-TIME high on that same day.

This expansion in breadth was positive for the health of the stock market, but the decline of the leading stocks caused some pain in investors' portfolios.

These losses left the stock market vulnerable to disruption, which occurred with the July jobs report on Friday, August 2.

That report showed that 116,000 jobs were added to the economy in July and that the unemployment rate had ticked up to 4.3%. The jobs added were less than the 165,000 analysts expected, and the unemployment rate rose from 4.1% in June.

Neither of these were "bad" results, but they were disappointing.

With the stock market undergoing a churning correction already, this was enough to push it lower that Friday. I

Investors were now nervous that the Federal Reserve had waited too long to cut interest rates and that the poor jobs report showed the first signs of recession.

Earlier that week (on July 31), the Bank of Japan had raised its key interest rate from 0.10% to 0.25%. This was a small move, but it was unexpected.

This did not impact the US markets that week, but over the weekend, concerns began to build that this might lead to an unwind of the "Japanese Yen Carry Trade."

What is that?

It is a trade that sophisticated global institutions have utilized. With Japan's interest rates near 0%, they borrow in Japan at this low rate and then invest it in other higher-yielding assets globally.

This isn't a trade that you and I could easily make; it is only available to the most sophisticated investors.

An increase of +0.15% in Japanese interest rates doesn't sound like much (and isn't), but investors were concerned about future increases.

The combination of these events led to turbulence beginning over the weekend.

Investors freaked out and sold the first asset they could – cryptocurrency. Bitcoin and Ethereum got hit hard.

Why sell cryptocurrency because of these concerns? It is the only liquid asset that is traded over the weekend, so it was the only one they could sell.

Going into that Monday morning, investors were panicking, pushing futures and options markets to elevated levels of fear.

The best measure of investor fear – the CBOE Volatility Index or VIX – traded at almost 40.

Here is the chart of that index going back as far as it has existed…

You can see this was the highest level since COVID. We are pretty sure we are not having another COVID event!

The stock market traded off in the pre-market and opened down big. Throughout the day, though, it rallied, and the week continued to rally.

It was volatile, but the S&P 500 ended up almost flat for the week. Here is a six-day intraday chart showing how it traded…

This incredible increase in volatility has led many investors to expect much more downside ahead. Many also expect the US economy to go into recession.

What do we think?

We think that many investors ignored the details…

First, the July jobs report had some anomalies.

The Bureau of Labor Statistics stated that the recent hurricane (Beryl) in Texas did NOT impact the numbers, but some data suggests otherwise.

Here is a category from the report showing people who have jobs but could not work due to the weather…

Almost half a million people said they had an issue, whereas the average July number was closer to 50,000. Remember that more than ONE MILLION people in the Houston, TX area had no power for two weeks.

Despite what the BLS says, this did likely play a role.

On our X/Twitter account we pointed this out and noted that the upcoming jobless claims data on Thursday would show if it were the case. Here is what we posted that morning…

That happened, and the market posted its best day in two years on the back of better-than-expected claims.

We think this will continue to be a positive catalyst for investor expectations about the economy. We have two more weekly jobless claims numbers and another jobs number on September 6.

We think all these will show that the weather impacted the July data and that the economy is fine.

What are our thoughts about the impact of a potential unwind about “Japanese Yen Carry Trade”?

We think that most investors don't understand it at all.

One of my university majors was Japanese, and I worked and lived in Japan thirty years ago. We have been active participants in that market for three decades.

We would ask a couple of simple questions…

Do we think these sophisticated institutions had thoroughly NOT thought about the potential for the Japanese Central Bank to raise rates?

Do we think that an increase of +0.15% REALLY impacts this trade?

The answer to both is NO.

These are some of the most sophisticated investors on Earth, and this was a tiny move. The "surprise" part upset some short-term market participants, but we think that the major money in this trade was prepared.

One last note: the governor of the Bank of Japan came out later in the week and noted that they would work to NOT surprise the market further.

In both cases, we think the stock market has overreacted. The fact that it closed FLAT on the week supports our argument.

Does this mean the stock market has bottomed?

We don’t know. EVERYONE points out the negative seasonality of this time of year and all the uncertainties.

What I will say is this – investors are a LOT less one-way enthusiastic than they were a month ago, and we have had some proper fear put into them.

THIS is a more constructive base from which to rally.