What's Behind the Market Swoon?
It's never just one thing and it demands a long hard look at everyone's current assumptions
When investment professionals use terms like “extreme volatility” and “market gyrations,” they usually mean they have just lost a lot of money for their clients. But if it’s easy to sugar-coat a massive loss of value on their watch, it’s a struggle to explain what happened and why.
Even yesterday, the experts were grasping at a variety of straws:
Weak U.S. Labor Data: This sounds good since the sharp drop followed two important releases last week. The problem is that they weren’t all that weak with unemployment still at 4.3%. Besides, investors worried about inflation for the last two years have been actually rooting for a cooler job market.
Yen carry-trade: Hawkish talk from the Bank of Japan probably spooked traders who were borrowing cheap yen to invest elsewhere. But it was obvious to anyone with a pulse that tighter policy was on the way and seems like only part of the story.
Disappointing earnings: Yes, Intel’s release surprised everyone as did Warren Buffett’s sale of Apple stock, but our friends at FactSet insist that 78% of the companies that have reported so far have exceeded expectations. And while 39 companies have issued negative guidance for the Third Quarter, 35 have issued positive guidance. Not great, but not bad.
Steep valuations: This feels a little closer to the mark. With a “soft landing” now the central assumption for most investors, there is plenty of risk in most portfolios. Risk and leverage are the classic formula for wild price swings. Still, if a forward PE of 20.7 looks steep compared to the five-year average of 19.3, is the economic outlook so much worse than any time since 2019?
Middle East escalation: Once again we are bracing for Iranian retaliation against Israel and the risks to global oil markets. But $75 a barrel hardly seems like the trigger for the next recession.
Systematic investors: Yes! Everyone loves to blame the quants! As market volatility spikes, some funds are forced to retreat from their riskiest positions, meaning a sharp drop in equity prices as they race for safety. Sharp swings can force risk models to recalibrate, too, meaning it will take some time before these pools of money will be ready to venture into riskier positions again.
The Rules: The Sahm Rule, named for a former Fed economist, posits that a recession is triggered when the three-month moving average of the unemployment rate rises 50 basis points from its 12-month low as it just did. But even Claudia Sahm dismisses the need for an emergency Fed rate cut. Meanwhile, the classic Taylor Rule (for Stanford’s John Taylor) would have had rate cuts starting much sooner, fueling the arguments that the Fed is “behind the curve.” Rules help focus analysis, but markets are rarely so mechanistic.
Inverted Yield Curve: This explanation would have you believe that after living with higher short-term rates than long-term rates since July 2022, the pain has finally kicked in. Those who like this explanation also like the version that the “disinversion” we witnessed this week is a sure sign that recession is at hand.
August: Bad things always happen in August is the corollary to “Sell in May and go away!” Think of World War One, the invasion of Kuwait and several Russian coup attempts. Also, average August returns have been negative since 1945 - except in election years.
The Bartlet Theory: A classic for West Wing fans, if not terribly useful for traders.
Note that this list does not include a “Kamala crash” as it’s hard for any vice president to have much impact on the S&P 500. But a sell-off as violent as this one must have more than one direct cause and it likely has several proximate causes that we have yet to uncover. In the coming weeks, we may learn that a large fund was caught very short or a systemic bank was caught very long. Amid the shifting valuations of currencies that come from central banks moving rates in different directions, we may see still more roiling markets.
And in a world as complex as ours, it will not be artificial intelligence that offers insight anytime soon. Ask Chat GPT about these markets and it lists “economic data,” “interest rates,” “corporate earnings,” “geopolitical events,” “market sentiment” and “global events” as possible contributors before offering: “it’s best to check the latest financial news and analysis for specific events or trends that might be influencing the markets.” (Thanks, Chat GPT!)
And yet as unhelpful as this algorithmic advice may be, it highlights the wisdom that market events require subtle and differentiated analysis that assesses a range of causes and weighs their potential impact. But even that’s not the hard part. The most difficult task lies in deciding what it all means for the conventional wisdom that underpins markets as they bounce around.
The evidence still points overwhelmingly to a soft landing, but what is the case for something much more painful?