Market Volatility Amidst Economic Noise: Analyzing Growth Concerns and Contributing Factors

Weekly Market Pulse: What? I Can't Hear You For All The Noise

Everyone wants an explanation for why markets move the way they do but you can't predict the emotions of people. I can calculate the movements of the heavenly bodies but not the madness of people. - Sir Isaac Newton, upon losing a fortune on South Sea Company stock Newton's Laws of Motion Last Monday, the stock market (S&P 500) fell by nearly 3%. We don't really know why it fell, although there are plenty of people who are ready, willing, and able to provide you with an "explanation". There's the Yen carry trade unwind, which says that leveraged speculators who had borrowed in Yen were caught off guard when the Bank of Japan raised rates by 0.15% despite the fact that the BOJ has spent months preparing the market for exactly that. Those speculators were supposedly using their borrowed Yen to buy US stocks and other risky assets, and so had to sell those assets to repay their Yen loans. While I generally agree with that assessment, there are some problems with it, namely that there is little evidence that is actually what happened. We don't get real-time information about non-bank Yen lending to hedge funds. In fact, we never really get that information, although it can be inferred - sort of - from other reports. I would also venture to say that the vast majority of pundits using this explanation have never met a trader doing this trade. I've been doing this for over 30 years, and I've only known a few who were doing it knowingly. What I mean by that is that in many cases the individual traders within a hedge fund have no idea the source of the capital they're trading; that's above their pay grade. Did the Yen carry trade have anything to do with the selloff in US stocks? Probably. There has certainly been a covering of Yen shorts in US futures markets, which is about the only thing we can really confirm. And, by the way, the short covering started in mid-July right about the time the S&P 500 peaked, although that could just be coincidence. Does that mean the Yen carry trade is over? Probably not, since the biggest structural short in the Yen is from Japanese households buying higher-yielding foreign assets. Last I checked, yields outside Japan are still a lot higher than inside. The other popular explanation is that recession fears have started to rise because of a few weak economic reports. That looked very plausible when the 10-year rate was dropping rapidly and expectations for multiple Fed rate cuts were rising. The 10-year yield had dropped 39 basis points from July 31st to August 2nd and fell another 13 basis points last Monday morning. But by the end of the day, bond yields were flat, and they closed the week up 15 basis points from the Friday close. At one point Monday, the market was pricing a better than 50/50 probability that the Fed would deliver a full 1% cut in the Fed Funds rate by the end of the year. By the end of the week, the only rate cut with better than even odds was for a 0.25% cut in September, and that only showed a 51.5% probability. Did the economic outlook change that much in just a week? One final explanation of the selloff is that earnings momentum for the AI stocks or the Magnificent 7 or Large cap growth stocks (or all of the above) has peaked and that without a clear path to profits from all this AI investment, investors are selling first and asking questions later. It is certainly true that earnings growth expectations for large cap growth stocks appear to have peaked (as I've pointed out numerous times over the last couple of months). But this explanation loses a lot of its appeal when you recognize that small and midcap stocks sold off as much as large cap (measured from the S&P 500 peak on July 16th) and their earnings expectations - and actual earnings - are rising. Everyone wants an explanation for why markets move the way they do, but as Isaac Newton found out the hard way, you can predict the motion of the "heavenly bodies" but you can't predict the emotions of people. In the short term, the market moves on fear and greed, and you can't predict in advance which emotion will dominate. Why have stocks corrected a bit over 5% since mid-July? Probably all of the above plus some things we haven't even considered. The bottom line is that people got afraid of losing money, and they sold in an attempt to prevent it or minimize it. We can't possibly know what exactly created that fear in each trader/investor, and frankly, it doesn't matter. The "reason" may well - likely will - prove ephemeral, or it may just be wrong. Or more likely, the "reason" was just something the investor invented to make themselves feel okay about doing what they wanted to do anyway. Newton's laws of motion actually do offer some pretty good advice for investors. There is no way to predict the emotions of people, but we can observe them and know that opportunity is found in the extremes. Market sentiment had gotten too exuberant by the first half of July (but not nearly as exuberant as we've seen at times in the past), a reversal was inevitable and we got it. Monday, after just a few weeks of selling, we reached another extreme in the opposite direction (but not as dour as we've seen at times in the past). The volatility index rose to over 60 Monday morning, an extreme by any measure of history, a reversal was likely and we got it. And sentiment remains fairly negative, unless this is a new bear market (which seems unlikely), which makes me think the correction may already be over. One word of warning, though. There's a lot of important economic data this week (CPI, PPI, Retail sales, two regional Fed surveys, industrial production and housing starts) and there is always the potential for a market-moving report(s). If you're a buyer, be deliberate and incremental and don't let greed overwhelm your good sense. What Sir Isaac Newton didn't understand about investing is that it doesn't matter that you don't know the motivations of others as long as you know your own. Don't get too greedy and don't get too fearful. The easiest way to do that is to back away, take a longer view. If you fell asleep 20 months ago and woke up last Friday, the 10-year Treasury yield would be no different than it was when you nodded off. The economy is not significantly different right now than it was then, despite some ups and downs along the way. If you fell asleep in June and woke up last week, the stock market would be in about the same place too. And if you were Isaac Newton and you awoke from the dead, you'd find out that you miscalculated a lot more than just the madness of people. The next time you think you know what's going to happen in the economy or markets, ask yourself: Am I smarter than Isaac Newton? Unless your last name is Einstein, the answer is probably no. Interest rates rose last week and the dollar was unchanged. Both are still in short-term downtrends but trading within the range of the last 20 months. Both are essentially unchanged over that time, a remarkable stability given all that has gone on during that time. Shorter term rates like the 3-month TBill rate haven't fallen as much as the 2-year because the Fed has not yet committed to a near term rate cut. The result is that the 10-year/3-month yield curve is more inverted now than it was in April. What does that mean? It means, we probably have more time to recession than the crowd currently believes. The 10-year/3-month curve has normalized before each of the last 4 recessions with an average lead time of about 5 months, but we aren't even close at -1.39%. There has been some attention paid to the fact that the 10-year/2-year curve turned positive briefly last week, but that can happen as much as a year in advance of recession. It has also stayed inverted until the start of the recession, but I think we have to be careful about putting much faith in these past episodes. Remember, the recession start date is chosen well after the fact and the committee that makes that decisions today isn't the same one that made that decision in 1980. There are going to be differences. The markets continue to reduce future nominal growth expectations, but a recession would likely see considerable downside to short and long-term rates. But for now, the trend hasn't changed and there is no credible trading signal to take on longer duration bonds. Despite a lot of cross-asset volatility, all the major asset classes in our diversified portfolios are up YTD. All but one - commodities - are up for the last year. And within the commodity allocation, gold has outperformed even the S&P 500 YTD and in the trailing one-year rankings. The last 3 years has been more difficult, with bonds and REITs - interest rate-sensitive assets - down and small-cap stocks up less than 2%/year. The best-performing asset over that time is commodities, which, as a diversifying asset, rarely holds a large position in your portfolio. The last 3 years was somewhat better for value stocks regardless of size, with small and midcap growth stocks down over that period. Owning any non-US stocks did nothing but lower your overall return. It hasn't been a fun 3 years. The last three years has been even tougher from a sector standpoint, with only Energy and Technology outperforming the S&P 500 over that time; industrials matched the market return. When will that change? Maybe soon because earnings growth has started to broaden out with non-tech earnings rising this quarter. The economic calendar was light last week and the reports were generally positive. The most important report of the week was one that usually doesn't move markets much - weekly initial jobless claims. The week before, claims jumped to 250,000 and the market seemed to take that as proof that the economy was failing rapidly. But as I pointed out last week, that level isn't anything special; we were actually higher last summer. So, last week's report was in the spotlight, and it didn't confirm the reading of the previous week. Claims fell back to 233,000. And frankly, that reading doesn't change anything either. Everyone looking at employment to try and gauge the likelihood of recession is looking in the wrong place anyway. Employment is a lagging indicator; companies lay people off after business slows down, not before. This week's calendar, however, is full of interesting and potentially market-moving reports: Credit spreads widened during the stock market correction, but are already off their highs and below last year's level. Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Why The Growth Scare May Be Over

This idea was discussed in more depth with members of my private investing community, The Financial Prophet. Learn More " We discussed not panicking and buying high-quality stocks while the market was in fear mode, capitulating, and selling just about everything early last week. Indeed, last week may have been the optimal time to buy, as the VIX rocketed to about 65, its highest level since the wild COVID-19 drop in early 2020. No, thankfully, we are not facing another deadly pandemic that threatens to shut down the global economy. Still, you have to admit. It's strange. Last week, the sky was falling, and now, it was "just a growth scare." Call it what you will, but this growth scare made the VIX go nuts, sparking a level of fear we have not seen in "ages." The recent VIX spike was much higher than last Spring and Autumn's pullback periods. The surge even eclipsed the bear market highs around the market's bottom in 2022. So, what caused this level of volatility to creep out of nowhere? This VIX spike has been coming for a long time. The market appreciated substantially in a relatively short time frame, and frankly, many market participants were looking for an excuse to sell and take short-term profits. Moreover, the "bad jobs report" and other data may increase the probability of recession in the next 6-12 months. Therefore, the market confronted a perfect storm. We had overheated technical conditions combined with stretched valuation and a level of uncertainty due to the recent job numbers and other data. These elements provide the ideal catalysts for a pullback, and during the height of the selling, we witnessed a considerable spike in the VIX. I emphasize the size of the VIX spike because it likely provided a substantial buying opportunity, and it's still a solid area to load up before the next round of buying begins. The "Nasdaq 100 ETF" (QQQ) is one of my favorite proxies for the Nasdaq. The QQQ slightly overshot my $450-440 buy-in area target, briefly dipping into the $430-420 range during the height of the correction. QQQ cratered by 16% from peak to trough, illustrating a considerable correction for the top tech stocks. Also, while QQQ kept its losses within the 20% range, many top tech stocks experienced heavy corrections. For instance: I know what you may be thinking. These are not corrections. These look like bear market declines. While the downside during the recent pullback has been excessive, it is arguable that the declines are proportional to the supersized gains we've seen in previous months. Many stocks that witnessed epic corrections participated in remarkable gains and are still much higher than the price they traded in 2022-2023. Here's how the same stocks have performed after bottoming last week (through Friday's close). The underlying stocks are up by: The point is that the returns have been very different and company-specific, but most stocks have just started to rebound, implying there could be much more upside ahead. Also, it has only been a little bit of time, and there is still significant uncertainty in the atmosphere. For instance, have the stocks bottomed? Will there be another retest of the lows? Is a recession coming? Are we in a bear market? Etc. Uncertainty is our friend now because it has brought these excellent stocks down to extremely attractive levels. Also, the only thing that seems certain is that the Fed will cut rates in September, which is very bullish for stocks and other risk assets. The market is currently mixed on whether the Fed will cut by 25 Bps or 50 at the FOMC meeting in September. The market will likely get its first rate cut soon. However, the question is whether it will react negatively if it's only a 25Bps cut. Even if the Fed cuts by only 25 Bps, the adverse reaction could be knee-jerk and short-lived. Also, the Fed must start the easing cycle as it should lead to higher growth, more liquidity, and potential future rounds of QE and other monetary stimuli. Furthermore, the funds rate is expected to be at least 100 Bps lower by early 2025, which should be bullish for high-quality stocks and the economy. Most of the earnings are behind us, and despite the lackluster stock performance, most of the earnings reports were solid, and much of the guidance was good. Again, the problem here was that many stocks had tremendous run-ups into earnings season, and the market expected extraordinary results from many firms based on the sky-high stock performance. Instead, the market mainly got solid earnings with satisfactory guidance, but this was not enough to support more upside in already overbought stocks, and many stock prices fell, which was logical and anticipated. Still, we will have several exciting earnings reports this week. I am looking forward to Walmart (WMT), Home Depot (HD), Deere (DE), and others as they could suggest the health of the consumer, an essential factor to monitor now. Additionally, chip giant Applied Materials (AMAT) will report. Also, the CPI inflation report and other crucial data points should be considered this week. This week, the market looks forward to inflation figures. First, the PPI will come out on Tuesday, but the critical reading will be the CPI on Wednesday. The CPI is a crucial inflation reading, and the market pays close attention to it. We received a favorable, lower-than-expected number last month, and the constructive trend of lower inflation should persist. However, we must avoid an inflation reading much lower than expected. 2.8% or lower in CPI may set off some alarm bells, as inflation may be falling too quickly, potentially bringing the market closer to its greatest enemy - deflation. Therefore, a 3.0-2.9% CPI should be fine. Yet, a 2.8% or lower CPI may imply that the economy is cooling more than expected, increasing the probability of a hard landing as we move on. Major average P/E ratios have declined with the recent selloff. The R2K has a forward P/E ratio of around 28 here, which is relatively cheap for the small/mid-cap index, especially going into an easing cycle. Therefore, we can probably expect a substantial upside amongst high-quality small and mid-cap stocks. The Nasdaq 100 now trades around 27 times earnings on a forward P/E basis. This valuation is also relatively inexpensive, given top tech stocks' enormous growth and profitability potential due to AI and other factors in future years. While the SPX may be least attractive, it still trades below 22 times forward earnings estimates, which is relatively inexpensive, especially as we head into an easing cycle. Furthermore, we may see increases in the SPX's future earnings estimates, and there's a possibility of better-than-expected earnings growth, implying that the true forward P/E on the SPX may be around 21-20 here. The market, and by the market, I am referring to the Mag 7 and other high-quality tech and AI-related stocks that spearheaded the bull market run since the 2022 October bottom, went up too much, too quickly. Many of the stocks we often discuss got ahead of themselves technically and from a fundamental valuation perspective. Whereas the gains were supersized, the corrections have also been epic. This is why we see 30-50%+ declines in some stocks, which is considered "normal" inside this bull market. These declines do not indicate that the underlying stocks are now in a bear markets. Despite the recent corrections and the possibility of persistent volatility, I remain constructive about high-quality stocks in the second half and going into year-end. Therefore, I am keeping my 2024 SPX end-of-year target range at 6,000-6,200.

Factors Contributing To Recent Equity Market Volatility

A positive is the fact that the civilian labor force continues to experience growth. Over the course of a little more than three weeks, the S&P 500 Index fell -8.48% from its high on July 16 to a recent low on August 5. Since last Monday's low, the S&P 500 Index has recovered about 3% of its decline. According to BofA Global Research, -5%+ corrections have occurred on average three times per year since 1930, and 10% corrections about once per year. Strategists have attempted to assign various reasons for the recent decline, with some reasons more plausible than others. What is clear though is the S&P 500 index has had a stellar first half to 2024, providing investors with a near-20% gain in the first seven months of the year as seen in the below chart. Perhaps investors were looking for a reason to trim some equity in their portfolios. For most of this year, the so-called Magnificent Seven stocks, the mega cap stocks with a heightened focus on artificial intelligence (AI), have contributed an outsize amount to the market's return. What seems to be evident is that some hedge funds and institutional investors have used leverage to invest in the Magnificent Seven group of stocks. One strategy utilized is known as the yen carry trade. This strategy is one where investors borrow funds in Yen as interest rates in Japan have remained near zero percent for years. The borrowings in Yen are then converted to currencies in other markets, for example, the US Dollar, and reinvested in those markets and in areas like the Magnificent Seven stocks. On July 31 the Bank of Japan increased interest rates by .25% or 25 basis points, the first increase since 2007. On the following Monday, Japanese stocks as measured by the Nikkei 225 Index (NKY:IND) declined a significant -12%. For those investors involved in the Yen carry trade, higher rates in Japan served as a tailwind for the Yen to strengthen; thus, making it more expensive for investors to convert the non-Yen currencies back into the Yen. Also, the increased interest rate made the Yen borrowings more expensive as well. Investors utilizing the Yen carry trade had to sell investments that were purchased with Yen borrowings, and some of those investments appear to be in the Magnificent Seven stocks. The end result was the Magnificent Seven stocks declined as the Yen strengthened as seen in the below chart. Also getting into the data mix was the Federal Reserve. The FOMC meeting ended on July 31 and the committee's stance on interest rates left rates unchanged, with a rate hike "on the table" at the next FOMC meeting in mid-September. Then, two days later, i.e., Friday August 2, and the Fed most likely had this information at hand a few days earlier, the July nonfarm payrolls number was reported at 114,000, lower than the expected 175,000. These numbers often get revised in subsequent monthly reports but, nonetheless, the market viewed the weaker payrolls figure as a weakening employment environment. One interesting data point in the July nonfarm payroll report was the increase in the number of individuals who stated they were not at work or were working part-time due to bad weather. This figure was reported at 1,550,000, up from 289,000 in June. What is known is Hurricane Beryl impacted the south, specifically Texas. In September 2017, a similar but much larger spike in this category was reported following Hurricane Harvey. As the months move forward, one would expect this variable to decline. A positive is the fact the civilian labor force continues to experience growth. This tends to occur as individuals on the sidelines move back into the labor pool looking for employment as they see job opportunities are available. This generally occurs when the economy is expanding and the first reading on GDP in July showed the U.S. economy grew at a 2.8% annualized rate in the second quarter, up from 1.4% in the first quarter. Lastly, on employment, a variable worth tracking is the monthly unemployment rate. As the below chart shows, the monthly rate recently crossed above the 12-month moving average of the monthly rate. Historically this has occurred near recessions and is similar to the recently cited Sahm Rule. In conclusion, what has been abnormal about the equity market this year has been the nearly uninterrupted move higher until this past month. When the CBOE Volatility Index (VIX) spikes, it is a sign of potentially higher equity market volatility in the subsequent 30-day period. On Monday last week, the VIX Index reached 66 on an intraday basis and likely signals at least a market bottom occurring sometime in the near term. The market will not move higher in a straight line, so investors should expect more volatility, especially as the presidential election nears. Not that the economy and the market are one and the same, but a growing economy is certainly positive for companies and hence stocks. A recent table from BofA Global Research shows ten variables the firm tracks to determine the likelihood of a recession. As seen below, only 3 of the 10 variables are signaling a market peak and prior market peaks have occurred when 70% of the variables are triggered. Certainly, there are concerns with the economy worth tracking, but at the moment more of the data seems to be falling on the positive side of the ledger versus the negative side. Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.