Yield Curve Inversion Sparks Concerns of Potential "Black Monday" in 2024

Black Monday 2024: +50% Drawdown, Says Yield Curve (SPX)

Looking for more investing ideas like this one? Get them exclusively at The Pragmatic Investor. Learn More " Stocks are selling off sharply on Monday following Japanese stocks and investors are beginning to panic. Yields are beginning to plummet, and the yield curve is uninverting after almost 700 days of inversion. The yield curve has only been inverted this long once before, and that was back in 1929, which preceded the Great Depression and a market sell-off of over 50%. There are numerous similarities between today's situation and what led to Black Monday in 1929 If history repeats, then an 80% drawdown is in the cards. The Yield curve has been a very accurate recession predictor over the last century. As we can see, when the yield curve uninverts, a recession soon follows, and recessions are almost always accompanied by bear markets in equities. And the longer the yield curve uninverts, the more impactful the recession tends to be. As we can see, only three times before have we seen the yield curve invert for over 400 days. 2008, 1929, and 1974. In all three instances, stocks sold off over 50%. More specifically, the yield curve has now been uninverted for over 763 days. This is the longest the Yield curve has been inverted since 1929 when the yield curve was inverted for 700 days, and that led to an 80% decline in stocks. While it's impossible to say with 100% confidence what sparked the crash of 1929, there are at least three key reasons we can point to that facilitated this decline. It is a well-known fact that speculation was rampant back in those days. Even commercial banks were making loans available to invest in the stock market, and this contributed to very high valuations during the Roaring 20s. Many stocks also rallied on the back of optimism around new technologies like the radio, manufacturing, and overall electrification of the economy. This was no doubt a revolutionary change that improved the olives of many, but as often happens, investors got ahead of themselves. This is a theme we have seen repeated since then. The 1990s brought about the Internet-fueled rally, which led to the dot-com bubble. Arguably, the Federal Reserve's rate hike also greatly contributed to sparking the 1929 sell-off. The Fed raised rates from 5% to 6% just before the big crash. This may have indeed contributed to tightening lending standards and perhaps even forcing margin calls. Is this at all similar to what is happening today? There are certainly some similarities. While margin trading is not at the levels seen back in 1929, options volume has exploded in the last year, especially when we look at 0DTE options. 0DTE options now represent around 50% of the trading volume in the SPX on any given day. While this isn't necessarily bullish/bearish, it can definitely lead to a lot of volatility and could contribute to sparking a fast and furious sell-off. Obviously, AI has helped fuel this market higher, and could now help the sell-off continue. The enthusiasm for AI has begun to die down, and that is clear if we look at how the market has reacted to some of the latest earnings. Alphabet/Google (GOOGL), for example, sold off after concerns were raised over the high costs of investing in AI. Indeed, Goldman Sachs (GS) recently raised concerns over the cost/benefit analysis of AI. And this is at a time when the AI darling, Nvidia (NVDA) is being investigated by the DoJ and delaying its latest AI chips. While the Federal Reserve is certainly not going to be raising rates, the Bank of Japan has, and that is arguably the main reason behind this sell-off. The BoJ has been on ZIRP for the better part of the last 30 years. Now, the BoJ has raised its policy rate to 0.25%, while also having its monthly bond-buying program. The result? A massive rally in the Yen and a sell-off in Japanese and global markets. This is leading to an unwind of the yen carry trade, which involves borrowing yen short and investing in foreign assets, namely US stocks. Arguably, this trade has helped support markets in the past, as we can see by the strong correlation between the Nasdaq and the Yen. As the yen appreciates, US stock markets will likely fall. While history doesn't repeat, it does rhyme. The Yield curve is uninverting, and though the US economy looks strong now, history says a recession will happen soon. Furthermore, we have a similar recipe today as we did back in 1929 ahead of that 80% market sell-off. Inflated valuations due to tech optimism, rampant stock speculation and also a tightening in monetary conditions, although this time it is coming from abroad. This sell-off could likely continue, but investors should be searching for opportunities to add to quality stocks. History also shows that it is best to be a net buyer. Recessions and bear markets happen just as surely as new highs in the market also do.

Another Black Monday - It's The Perfect Storm

The market selloff is just starting with the S&P 500 approaching the 10% correction, but it will be volatile with sharp rallies as well. August 5, 2024, the global stock markets started crashing in Asian trading hours. Japanese stock market index Nikkei 225 (NKY:IND) is currently down by almost 13%. The US markets are currently closed, but the futures point to a deep selloff, Nasdaq 100 futures (US100:IND) (QQQ) are currently down by almost 6%, while the S&P 500 futures (SPX) (SP500) are down by over 3%. This is developing into a stock market crash similar to the 1987 crash. The stock market is in a perfect storm, where many negative factors are converging all at once. The first factor that's causing the crash is related to what is called the Yen carry trade. Essentially, hedge funds were able to borrow in Japanese Yen at zero interest rate, no cost, and sell Japanese Yen (FXY) for the higher yielding currencies, such as the US Dollar (UUP) and Australian Dollar (FXA), and these funds were also invested in risk assets like stocks. One of the most favorable institutional stock market trades was in US tech stocks due to the Gen AI theme. The Yen-funded stock market speculative trade worked fine as long as the Japanese Yen did not appreciate, as institutions eventually need to convert the funds back into Yen. The Yen-carry trade is generally unhedged, and the spike in the Japanese Yen forces the borrower to liquidate the Yen-funded investments. Just recently, the Bank of Japan increased interest rates with more monetary tightening likely ahead, while the Fed is expected to start cutting interest rates, possibly in September. This is causing the interest rate differential between the Japan and the US to narrow - and causing the Yen to appreciate. So, that's the first factor, the appreciating Japanese Yen, which is currently up by almost 3%, and sharply higher since July 15 (which is when the S&P 500 peaked). Independently from the need to sell the Gen AI themed stocks due to the spiking Yen, the Gen AI bubble is bursting due to the realization that Gen AI is not that transformational technology that it was hyped to be. Specifically, starting with the Alphabet (GOOG) (GOOGL) earnings call it seems like the Gen AI Capex is not very profitable, but the Gen AI related companies are still heavily investing in Gen AI due to the fear of being left out. As Alphabet said it, "the risk of overinvesting is greater than the risk of underinvesting". This statement by Alphabet burst the Gen AI bubble. The other tech mega-caps, like Microsoft (MSFT) said that these Gen AI investments are fungible, meaning the infrastructure can be used in other areas, and this is not a vote of confidence for Gen AI. The valuations for these tech mega-caps were in bubble territory due to the Gen AI hype, but now as the reality about Gen AI sets in, the bubble is starting to burst. The US economy has been slowing for some time - the pandemic related savings are depleted, and the Fed kept the yield curve inverted for the record length of time to beat the post-pandemic inflation, which historically always precedes a recession. Market participants were hoping for a soft-landing, but just last Friday the Sahm Recession Rule was triggered, which signals that the US economy is entering a recession. Specifically, as the US unemployment rate increases by 0.5% from the low point, based on the three-month averages, the US economy enters a recession. We are currently in that situation with the Sahm value above 0.5. In other words, the US labor market is slowing to the point where a recession might be imminent. With a recession, the US stock market faces a recessionary bear market, beyond just a Gen AI bubble burst. However, the Fed still does not view the current macro environment as recessionary. Specifically, the FOMC failed to signal the cut in September by not changing the key sentence on the post FOMC statement, and the Fed Chair Powell said that the current labor market is just "normalizing". Specifically, Powell sees the recent increase in the unemployment rate mainly due to the increase in labor supply, which is still due to the post-pandemic normalization in the labor participation rate and immigration. The recent data actually agrees with Powell. The market is now expecting the Fed to sharply cut interest rates in 2024, but the Fed does not seem to be willing to come to the rescue yet. On top of everything, an attack by Iran on Israel could be imminent (meaning today), and the words can't really describe the dangers associated with the major geopolitical escalation in the Middle East. Iran's attack on Israel in April caused a 10% correction. The market risk of a possible attack is a possible spike in crude oil prices (USO), which could interfere with the Fed's ability to ease interest rates. Systematically, the Middle East geopolitical escalation could cause a major flight to safety and risk off behavior, which also boosts the Yen, and in addition could accelerate the global recession. The stock market is in the perfect storm, which could produce a major crash in the near term. This is all happening at the same time. However, even with the overnight drop in SP futures, the S&P 500 is still up by 6% YTD. That means that it's still appropriate to sell. The current drawdown in the S&P 500 right now is at around 10%, while the total drawdown is likely to be 30-50%. However, the trade will now get more volatile, with the sharp bear market rallies. The current 10% correction is not the time to buy yet. Traders could bet on the short-term spike, but investors should remain patient. What happens over the near term depends on how the Fed responds, via the Fed speakers. I don't expect the Fed to come to the rescue yet, but let's see. At this point, the S&P 500 is in crash mode.