Don’t Panic Over Market Plunge — Fed Will Cut Rates Sooner #CashNews.co

Markets cratered around the world Monday. Japan’s Nikkei fell more than ever — down 12.4% while “benchmark indexes in South Korea and Taiwan were both down more than 8%,” noted the Wall Street Journal. The S&P 500 opened down “about 4% Monday, with the Nasdaq falling a larger 6%,” the Journal reported.

Unless you are feeling adventurous — in which case now could be a good time to buy companies on your shopping list at a lower price — just hold on.

Why? In recent decades, much worse things have caused markets to collapse. Yet fewer than six or so months afterwards, stocks renewed their upward climb. Why incur the transaction costs of selling and then trying to buy in at the bottom — which you are unlikely to pinpoint?

To be sure, I do not know what caused markets to decline in the last few days. There is simply not enough information about who the biggest volume traders are and why they are making the moves that are driving down stock prices.

Nevertheless, the right move for most investors could be to do nothing.

Did Market Overreact To July’s Bad Jobs Report?

Some of the reporting about what caused the market downturn seems to be based on flimsy thinking. For example, an August 2 jobs report revealed nonfarm payrolls increased 114,000 in July — 69,000 short of economists’ forecasts, according to the Wall Street Journal.

Stocks fell — with the S&P down 1% — despite the market’s natural instinct that the lower-than-expected jobs reports would be likely to encourage the Federal Reserve to cut interest rates sooner as the unemployment rate increased 0.2 percentage points to 4.3%, the Journal reported.

Rather than raising stock prices in response to a sooner than expected rate cut, shares fell on “concerns that the Federal Reserve may have missed an important opportunity” to cut rates on July 31, reported the New York Times.

One months’ disappointing jobs report is not an emergency. However, the Fed can always cut interest rates between meetings. Otherwise, perhaps the Fed will cut interest rates more than expected at its September meeting.

One analyst suggested the bad July jobs report could be an anomaly. “When you look at the labor market report in a bit more detail, I think there are some legitimate concerns about whether it was actually as weak as it as it was stylized,” Peter Schaffrik, global macro strategist at RBC Capital Markets, told CNBC on Monday.

Are Fears Of The Carry Trade’s Collapse Overblown?

In a “carry trade” investors borrow money in a country with low interest rates and invest the proceeds in a country with higher rates.

Another possible cause for the U.S. market’s drop was the record decline in Japan’s Nikkei index. Why did that happen? There is speculation that the yen/dollar carry trade had “imploded” due to Bank of Japan’s interest rate “hawkishness,” reported CNBC.

Such extreme moves are often a result of panic selling driven by investors who borrowed money to place a bet that abruptly goes against them. To repay the money they borrowed, traders must liquidate their positions as the market is falling — which creates tremendous downward pressure on asset prices.

The rapid increase in market volatility — the so-called Vix more than doubled between July 31 and August 5 when the Vix hit the highest level in four years — makes it even more painful to unwind a bad trade.

(”The VIX is calculated based on market pricing for options on the S&P 500,” noted CNBC — measuring “expected volatility over the next 30 days.”)

My guess is some investors were borrowing money in yen to buy in dollar-denominated assets expecting the Japanese interest rates to remain low while the Fed kept rates high.

When those assumptions proved wrong — particularly after the market’s response to the bad jobs report and the Bank of Japan’s decision last week to raise interest rates — those investors had to close out their positions fast.

The suddenly high Vix forced “people to take down their positions overall,” Schaffrik told CNBC. “And obviously, they have to sell into a falling market already, or have to buy into a rising market in the case of Treasurys. And that then reinforces itself.” he added.

The fate of the carry trade most likely will not cause stocks to collapse.

Why Investors Should Not Panic Sell

There are two reasons investors should not sell:

• Flash crashes like what happened to the Nikkei Monday are fleeting, and
• Selling after a previous day’s big fall is a money-losing strategy, noted the Journal.

Why Flash Crashes Are Fleeting

A look at the Nikkei’s price chart over the last year reveals a steep upward movement. Investors from around the world have been betting the Bank of Japan would keep rates low — as it has for the last 17 years — through trades that lowered the Vix, the Journal explained.

When the Bank of Japan decided last week to raise rates, these bets suddenly looked very bad as the Vix spiked dramatically. “Whenever a panic breaks through this” low volatility trade — which happened when the Vix soared “above 50, making it the highest weekly jump since the onset of the pandemic,” noted the Journal — the selloff is “disproportionate.”

Indeed the yen rose 7.6% against the U.S. dollar over the past week. The rising yen fed on itself as investors who had borrowed yen were hit by their bankers with margin calls as the currency jumped — forcing them to buy yen to come up with the collateral and “triggering still-further margin calls,” reported the Journal.

Why Selling After A Bad Day Yields Poor Investment Returns

After the market falls, the best strategy is sitting tight. Looking at S&P 500 returns since 1994 shows that selling “based on the previous day’s falls is a bad strategy,” according to the Journal. While moving into cash after large monthly declines is better — doing nothing is best, added the Journal.

It helps to look at recent stock market collapses to realize the wisdom of sitting still. In the early days of the pandemic, stocks fell by more than 25% within a month. Yet a year later, market gains had more than wiped out these losses, the Times reported.

Or consider the biggest market collapse in recent memory — the 2008 financial crisis — which reached its peak in mid-September 2008 when Lehman Brothers went bankrupt.

Between that bankruptcy and March 2009, the S&P 500 fell 40%. After that stocks began to climb out of their hole and as of August 5, 2024 the S&P 500 had risen 590% from 756 to 5,213.

Keep calm and carry on.