Panic started creeping into the markets at the end of last week after a weak jobs report, and last night (Sunday 8/4/24) it escalated big time. Japan’s Nikkei took a nosedive, the likes of which we haven’t seen since 1987. This fear has spread like wildfire, especially around the carry trade. Here’s what is happening.

Since at least 2023, speculators have been borrowing in Japan at rock-bottom rates. They took that cheap yen, converted it to dollars, and loaded up on the Nasdaq 100. This pumped the yen down and the Nasdaq 100 up. But now, the carry trade is coming undone as the yen soars thanks to the Bank of Japan tightening the screws.

The panic hit hard last week, hammering tech stocks with some brutal double-digit declines from their highs. Recall that technology is the largest component of the S&P 500, so the drawdown carried all indices lower. Such steep drops make investors jittery. Everyone’s looking for a market turnaround, and some think it hinges on the Presidential election—the stock market is closely tracking Trump’s odds of winning in November. The market has also entered its seasonally weakest period with August and September historically being two of the worst performing months for stocks.

As we climb the wall of worry, another worry points to the Sahm Rule, indicating the US is already in a recession. The recession indicator jumped to 0.53 in July from 0.43, suggesting a recession. This rule flags a downturn when unemployment rises 0.5 percentage points above its previous 12-month low. With the unemployment rate up to 4.3% in July from 4.1% in June, the Rule has triggered. Historically, this indicator has never given a false signal, and each time it’s breached, the unemployment rate spike accelerates.

While it is obvious things have slowed, it appears the rule may be overstating the labor market’s weakening due to unusual labor supply shifts from the pandemic and immigration. The US economy has been on an incredible run over the past decade. John Caple from Hidden Harbor illustrates this long-term performance well with this chart:

The market’s down. Unemployment’s up. Recession talks are back. Fear is driving investors to irrational decisions. While there are always reasons to sell, the Federal Reserve still has a few levers to pull. The Fed has around 5.5% in potential interest rate cuts to stimulate the market if a recession looms. Most expect the central bank to start those cuts in September, just in time to fend off a severe downturn.

This is one of our favorite charts from the Ritholtz team showing all the reasons an investor has had to sell stocks since the Great Financial crisis and how, over time, the market has just grinded higher:

In 2020 the Fed fired every bullet it had (interest rate cuts, printing trillions, etc.) and it worked. The market responded exactly how we wanted. The Fed is reloaded and ready for action if they must intervene again. No one can predict with absolute certainty whether a market correction will reverse course or spiral into a bear market (a downturn of 20% or more). However, history shows that most corrections don’t turn into bear markets. Since November 1974, we’ve seen 24 market corrections, and only five have morphed into bear markets—those being in 1980, 1987, 2000, 2007, and 2020.

At the end of the day, worrying excessively about a bear market can be counterproductive, but being prepared is always a smart move. Here are some steps every investor should consider during volatile stretches:

Create a Financial Plan: If you don’t have a financial plan, now’s the time to make one. A written plan can help you build a balanced portfolio and be your north star during market turbulence.

Review Your Risk Tolerance: It’s easy to take risks when the market is climbing, but downturns can reveal how much risk you’re truly comfortable with. Assess how much loss you can handle emotionally and financially. All our clients go through an investor profile questionnaire that helps determine their risk profile and match it to an appropriate asset allocation.

Rebalance Regularly: Market fluctuations can shift your portfolio away from its original target allocation. Rebalancing involves selling assets that have become overweight and buying those that have become underweight. It’s wise to rebalance at regular intervals to maintain your desired allocation.

Consider Your Life Stage: If you’re a younger investor with a long-term goal, you have time to recover from market drops. For those nearing or in retirement, regular rebalancing and diversification are crucial. As retirement approaches, your risk profile should become more conservative. If you’ve recently retired and started withdrawing from your portfolio, be mindful of the impact of poor returns early in retirement. To avoid selling assets in a down market, consider reducing withdrawals or postponing large expenses.

By following these steps, you can better navigate market volatility and stay on track toward your financial goals.

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