The first full week of August was exhaustingly boring—that is if you viewed it from beginning to end. It was a wild ride in between. The S&P 500 remained essentially unchanged for the week of August 5 through 9, but a lot happened throughout the week, which could impact the market’s return for the rest of the year and the next twelve months.
That week, the S&P 500 saw its best and worst single-day returns since the start of 2023. On Monday, it was down three percent, and on Thursday, it was up 2.3 percent. On Monday morning’s lows, the S&P 500 was down 4.25 percent, but it somehow closed the week up 0.02 percent. The SPDR S&P 500 ETF (symbol: SPY) tracks the S&P 500 index. In the history of the SPY, there have been 13 prior weeks where it was down at least 4 percent at its intraweek low and still ended the week higher, according to Bespoke. In Bespoke’s graphic below, you can see that the average returns of SPY have been higher three, six, and 12 months after those occurrences.
Three months after such a weekly decline and recovery, SPY averaged a 4.33 percent return. One year later, it was up 14.19 percent. Sometimes, the sun shines on the stock market after it weathers a storm.
At the heart of the market volatility was the rapid unwinding of the Japanese yen-carry trade, a popular strategy among global investors for years. (The yen is Japan’s currency.) Japan’s interest rates have been near zero for decades. The yen-carry trade occurs when investors borrow cheap money in yen and invest those proceeds in higher-yielding investments. It is more costly than you may anticipate, so investors borrow billions of dollars at a time and use significant leverage to make any real money. Remember that using leverage at the wrong time is how wealthy individuals quickly face financial ruin. Here is what happened:
- On July 31, the Bank of Japan (BOJ) surprised markets by raising interest rates by 0.25 percent.
- This unexpected move caused a dramatic strengthening of the yen against the dollar.
- As the yen strengthened, investors who had borrowed in yen to invest in higher-yielding assets (the carry trade) were forced to unwind these positions quickly.
- Japan’s stock market was down 12 percent in a single day, its largest decline since Black Monday in 1987.
- This unwinding created a cascade effect, resulting in selling pressure across asset classes worldwide.
Terrified, many market pundits urged the Federal Reserve to make emergency interest rate cuts to save the economy. In response, the federal funds rate futures market now indicates a 75 percent chance that the Fed will cut rates by 100 basis points or more at its last three meetings this year. Not only does this exceed the Fed’s current guidance, but it would necessitate at least one 50-basis-point rate cut, something Federal Reserve Chair Jerome Powell has said is not on the table.
The stock market will likely remain choppy in August. There is simply too large a disconnect between what the market wants the Fed to do and its willingness to communicate between now and its September meeting.
While I am concerned, I am not freaking out. Why not? I believe there is at least a coin flip’s chance of avoiding a recession in the U.S. for a while longer.
First, three-fourths of the yen-carry trade has been unwound, according to JP Morgan. Most of the stress is behind us. And the Bank of Japan said, and I am paraphrasing here, “Whoops! We won’t do that again.”
Second, some of the concern about the economy being in danger was due to one single monthly payroll report that came in below expectations. The unemployment rate rose from 4.1 percent to 4.3 percent, but that was mostly a function of the numerator: more people entering the workforce. A healthy economy should add at least as many jobs as net new people are entering the workforce, and that is about 160,000 per month. The average job creation for the previous three months was 170,000.
Recent job creation is down from 225,000 jobs per month in 2023. That is an example of the economy normalizing, not contracting. Gross Domestic Product (GDP) has not shown many signs of weakness. The Atlanta Fed GDPNow tool forecasts GDP for the current quarter at 2.9 percent. That compares to the previous four quarters, which annualized 3.125 percent, and is far from recessionary.
Earnings for the S&P 500 companies were about $60.13 per share in Q2 2024, higher than their $58.91 peak in Q3 2013. Profit margins are at 12.3 percent, above the five-year average of 11.5 percent, which is a sign of robust economic activity.
The economy is not the stock market, and vice versa. However, a sustained economy often means the difference between a 10 percent market correction and a 30 percent bear market. As of the time of writing this column, the S&P 500 had dropped 8.5 percent from its July 16, 2024, high. I do not believe we have seen the lows for the year yet. The rest of 2024 could be reminiscent of 2023. Per the below Bespoke graph, the two years look similar so far.
I suspect the index will continue to struggle through the summer, hit the lows for the year in October, and then rally in the fourth quarter. The downside risk for the S&P 500 is somewhere in the 4,900s, a bit below the index’s 200-day moving average. There is some room around the edges of portfolios to reduce beta, either by reallocating equity classes or increasing bond exposure. However, as Scott Little from Berkshire Money Management recently texted me, there is “more volatility ahead, likely rewarding a do-nothing strategy” regarding a well-invested portfolio.
Allen Harris is an owner of Berkshire Money Management in Great Barrington and Dalton, managing more than $700 million of investments. Unless specifically identified as original research or data gathering, some or all of the data cited is attributable to third-party sources. Unless stated otherwise, any mention of specific securities or investments is for illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable. Full disclosures here. Direct inquiries to Allen at AHarris@BerkshireMM.com.
