Correction vs Bear Market

Introduction

Global stock markets during the week 7/29/2024 – 8/2/2024 experienced heightened volatility and a decline in index values.  Returns for the week and year-to-date for the US markets appear in the table below.

The CBOE volatility index, or VIX, is an indication of investor fear.  On Monday August 5^th it rose 134% to 55, a level that it hadn’t reached since 2008 with another very large drop in the value of the indices.  There were a series of triggers for this sell off, primarily recession fear.  The question now is, is this a simple correction in the bullish trend or is it the beginning of a bear market?

Definition of a Bear Market

A bear market occurs when a stock market index drops 20% or more from its peak. A bear market is typically accompanied by a weakening economy and lower corporate earnings, all leading to investor pessimism. As of this time, none of the stock market indices are down 20%. 

Technically speaking, the market is close to a top and as a result, increased volatility is expected.  The difficulty with technical analysis, however, is that market timing strategies are notoriously inaccurate.  The market could keep going up for a significant period. It is also possible and should not surprise anyone if the market continues to decline, at least in the near term.  One important gauge of market and economic health is corporate profits. Widespread declining profits indicate a heightened risk of a bear market.   Corporate profits, for the second quarter of 2024, were largely positive.

Mixed Economic Indicators

Another sign of a looming bear market would be steadily declining economic indicators.  In respect to current economic indicators, the advanced second quarter 2024 GDP growth released on 7/25/2024 was 2.8%.   The GDP number is a strong number and well above the consensus estimate of 2.0%.  The Federal Reserve did not reduce interest rates at its last meeting as it continues to monitor inflation and economic data. After the FOMC meeting, the economic data has shown mixed results. For example, productivity numbers have been improving, a positive sign.  On the other hand, manufacturing data, durable goods orders, construction spending and home sales declined.

On Friday, 8/2/2024 the initial unemployment claims number was released. The number was 4.3% vs. 4.1% previously.  Market participants focused on an indicator called the Sahm Rule. Hemispheres believes that this rule was applied erroneously, as explained below.

The Sahm Rule

Claudia Sahm, a former economist at the Federal Reserve, developed the Sahm Rule in 2019. The rule serves as an early indicator of a recession and is specifically designed for fiscal policy adjustments, not for monetary policy changes. The rule states that if “the unemployment rate increases by half a percentage point from its trough of the past 12 months, the economy is in a recession. To smooth out the figures, both the current unemployment rate and the trough are measured as three-month moving averages” [1].

In an article published in the Economist 11/14/2023 Ms. Sahm pointed out that in the post-pandemic economy companies are quick to lay off workers.  This recently occurred with Hurricane Beryl.  Many workers filed for unemployment after being laid off on a short-term basis, which skewed the unemployment rate. Additionally, Ms. Sahm noted that “the increase in the jobless rate appears to have been driven less by a reduction in demand for workers and more by an increase in their supply.” The labor force is expanding faster than job growth, possibly due to the government issuing work visas to immigrants. This feature also reduces the reliability of the Sahm Rule.  In respect to unemployment and the Sahm Rule, market participants over reacted.

What triggered the Sell Off Last Week?

The Treasury International Capital (TIC)

This monthly indicator is also known as Net Long-Term Securities Transactions.  On July 18^th the Treasury reported that foreigners sold $54.6 B in US securities, including Treasuries and all other securities including stocks and bonds.  The TIC reports data from 45 days prior to data release.  While this number vacillates between positive and negative values every month, this was a large level of outflows from the US markets that certainly may have contributed to last week’s market sell off.

The Unwind of The Carry Trade

On July 28th, the Central bank of Japan unexpectedly “raised its cap on ten-year government-bond yields, which it defends with regular and sometimes vast purchases, from 0.5% to 1%. Ten-year yields climbed to around 0.57% after the announcement, the highest in nearly a decade. The BOJ’s ultra-low interest-rate regime, introduced to boost the country’s sluggish rate of economic growth and prevent outright deflation, has now been active for a quarter of a century.”[3]  The Central Bank action resulted in a rapidly strengthening Yen.

Because Japanese rates were so low and the Yen was weak, many financial institutions and investors borrowed Yen denominated debt to invest elsewhere to earn a higher return.  This type of transaction is known as a carry trade.  As the Yen strengthened the economic benefit of the “carry trade” lost its luster and forced selling of US securities. We should note that the BOJ had previously voiced its intention to further tighten monetary policy.  Due to last week’s global market shock, the BOJ walked that comment back decisively this week.

Artificial Intelligence

Artificial intelligence related stocks have materially outperformed the market since early 2023.  The majority of stock index returns for the past year and a half have been generated by the “Magnificent 7.”  Recently, there has been growing concern that these companies are not earning adequate returns given the level of capital expenditure dedicated to the development of AI technology.  With the unwinding of the carry trade and a spike in volatility investors reduced risk and locked in profits by selling.

Geopolitical Stress

The continuation of war between Russia and Ukraine, escalation of hostilities in the Middle East and a major election cycle all contribute to global market volatility.

Conclusion

After a shock like we experienced this past week, markets tend to retest the lows before heading higher.  Investors should neither be surprised should this occur, nor should they panic.  History proves that the best strategy is to hold on for the long term. Market volatility will likely be elevated for some time.   This decline in market value more likely represents a correction.  The criteria for a bear market have not been met at this time.

The principles of Hemispheres Investment Management have over 35 years of investment experience across multiple market cycles.  We view down markets as an opportunity to add industry leading stocks at discounted levels thereby enhancing long-term returns.  Hemispheres Investment Management flagship product is its Global Equities Strategy that provides clients with the ability to diversify their portfolios globally.

Please contact Hemispheres Investment Management for a free consultation. We provide guidance and strategies to assist you optimize your investment policy and help you achieve your investment goals. Book a meeting.

[1] America may soon be in recession, according to a famous rule (economist.com)

[2]  America may soon be in recession, according to a famous rule (economist.com)

[3] The Bank of Japan jolts global markets  (economist.com)