By Matthew Gaude & Shawn McGuire
Monday morning is bringing an avalanche of negative news headlines. Let’s go through briefly what is causing the decline in world markets.
First, you will see news headlines about Japan, like this one from CNN:
The reason Japanese stocks are declining and leading to world markets declining is because of a reversal of a popular investment strategy that was used by hedge funds and large institutional investment firms, by using leverage.
The simplification of this strategy: An investor borrows Japanese government bonds and takes the proceeds and uses them to buy risk assets: stocks, emerging market debt, commodities, crypto, and even U.S. corporate and government bonds. This trade has been utilized for more than two decades thanks, mostly, to the fact that the Bank of Japan has kept interest rates artificially low (and much lower than the rest of the world).
Here’s how the trade works: I’m a big investment fund. I place a trade to sell the 10-year Japanese Government Bond. My “cost” to borrow the bond is the yield (more or less) and recently, the yield on a 10-year Japanese Government Bond was 1.08%, which is being controlled by the Bank of Japan, so I don’t have to worry about the bond moving too much. I then take the proceeds from my short sale and I buy something: stocks, bonds, commodities, crypto. Since it only costs me 1% per year to borrow the money, any gain above that is profit (ignoring any currency movements). But if I’m more conservative, maybe I just buy a U.S. Treasury yielding 4.20%. I make a 3.20% spread on the trade, and as long as the yen doesn’t strengthen more than 3% vs. the dollar, I’m good. The yen carry trade has been used to fund bull markets in virtually every asset over the years, and for leveraged funds that know how to do it, it’s been a great source of returns—until recently when the Bank of Japan increased interest rates for the first time since 2007. However, there is always the risk this trade reverses, which is what is happening currently. Only so many people can go through the exit at one time. And because they are done on a lot of leverage, it doesn’t take that big of a move to pressure the markets. This is a major contributor to the declines we are experiencing Monday.
What’s happening now is not because of a Federal Reserve error by not lowering interest rates last Wednesday. It’s driven by the popping of a bubble described above and its knock on impacts on other positions.
Combine this overcrowded trade with geopolitical tensions escalating in the Middle East, underwhelming A.I.-related earnings reports from Amazon, Microsoft, and Alphabet, and a concerning jobs report from Friday—things can get ugly quickly.
As a result of these moves in global markets, this has increased volatility exponentially.
As you can see below, there have only been two other times since 2000 we have experienced volatility this high. The first in October 2008 during the Great Financial Crisis and the second in March 2020, during COVID. This will be the third time where we have seen the volatility index above a level of 50. Historically, times like these have presented opportunities.
Another favorite indicator we use is the Fear and Greed indicator:
The Fear and Greed indicator is currently at 18, in the “extreme fear” level. Historically, readings in the “extreme fear” level present opportunities.
An important note as volatility returns for the first time in years: For most investors, bear markets or sharp declines are actually even an even bigger opportunity than bull markets. While the headlines are often frightening, some of the greatest companies in the world go “on sale.” Investors with a long-term investment horizon should welcome declines in the markets. These markets give you an opportunity to purchase high-quality companies that are “on sale.” As people get more fearful, look to get more greedy. And if you zoom out far enough on a chart of the U.S. market, you’ll see that 100% of bear markets have been good buying opportunities.
Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review by clicking here.
Matthew Gaude J. Shawn McGuire
About Matthew
Matthew Gaude is an *investment advisor representative and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. Working first as a commodity broker and then as a Business Development Manager for a national broker-dealer in previous jobs, he has the insight and experience to help clients understand the complexities of the market and implement strategies to minimize risk. To learn more about Matthew, connect with him on LinkedIn or visit www.liveoakwm.com.
About Shawn
Shawn McGuire is a financial advisor and the co-founder of Live Oak Wealth Management, a financial services firm in Roswell, Georgia. He serves the planning and investment needs of corporate employees, those approaching or in retirement, and 401(k) plan sponsors. He has worked in financial services since 2002 in positions ranging from financial advisor to stock broker and portfolio manager. As a CERTIFIED FINANCIAL PLANNER™ professional, he is trained to help clients with virtually all their financial needs. To learn more about Shawn, connect with him on LinkedIn or visit www.liveoakwm.com.
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