Market Mayhem – What’s Happening?

August 5, 2024

By Robert Wiedemer

Japanese Stock Market Has Collapsed

Last night the Japanese stock market, as measured by the Nikkei 225, plunged 13%. When Friday’s losses are added in, the Nikkei was down 18% -- in only two days.

Very scary -- for Japan and world markets just waking up to the news. In fact, the S&P opened today down over 5% but rallied back quickly and closed down “only” 3%.

It was obvious why the Japanese market was down: After decades of easy money policies where the Bank of Japan has kept rates low and printed massively to do so, they have decided to pull back. They are letting interest rates rise and promising to greatly reduce purchases of Japanese government bonds with printed money.

That’s a huge change for Japan.

Did the Japanese market overreact? Possibly. But rising rates are a big problem for Japan’s economy and its stock market. The last thing the fairly weak Japanese economy needs right now is a big rate increase. So why did the Bank of Japan decided to do it now?

Again, the reason is obvious: The yen has been falling steadily this year because interest rates are too low to attract foreign investors. When most of Europe and the US is offering rates in the 4% range, it’s hard to get investors to buy Japanese bonds that only pay 1% or lower. The Bank of Japan could make up for the loss of demand by printing even more money to buy more bonds, but it has decided not to do that.

Fear of Recession is Also Hurting the Market, but Is a Recession Coming?

Although the Japanese market collapse has spooked world markets, I suspect that the US market downturn due to jitters over Japan’s market will be short lived. It’s clearly a Japanese issue and it will not affect the US economy to any great degree.

However, there is another reason for the market to be nervous and that is a renewed fear of recession. But how real is that fear?

Let’s First Look at the Amount of Government Stimulus

Whenever discussing a potential recession, the most important indicator to look at in the current highly unusual economy is “how much stimulus is Congress providing the economy?” Since the Financial Crisis, and much more so after Covid, this is the key to recession.

The answer to that question is that Congress is on track to provide about $1.9 trillion in economic stimulus to the economy this year, up from $1.7 trillion last year.

$1.9 trillion is equal to about 7% of our GDP. That’s a lot of stimulus.

It’s usually not referred to as stimulus. It’s usually called deficit spending or government borrowing, but it is most definitely stimulus.

With no big decrease there, and actually an increase, my fear of recession is fairly low.

A Recession is Unlikely, but a Slowdown is Guaranteed

Although it is hard to have a recession when government stimulus remains high and interest rates are falling (the 10 year rate has fallen to 3.7%), it is quite possible to have a slowdown. In fact, for the US it is guaranteed.

First, the big boom in hiring after Covid is slowing down and higher interest rates are hurting sales of capital goods. Second, we are going to see a continued slowdown in construction of offices, housing and retail. Third, industries related to home sales (mortgages, real estate brokerage, furniture, appliances, home improvement) have been hurt due to the very big decline in home sales.

Predictions of Recession Have Been Going on for Some Time and Have Continually Been Wrong

Part of the reason many analysts and investors are calling for a recession is that they see the economy as being the same as in the past. For one thing, they almost never discuss what has become the most important recession indicator – government stimulus.

They primarily look at indicators or tools that may have been good in the past but may have little merit in today’s economy, such as an inverted yield curve or the Sahm Rule.

As part of seeing the economy as being “normal” many investors and analysts wanted to see a repeat of Fed Chairman Paul Volcker rate increases in the early 80s. That means a big increase creating a big recession which kills inflation and lays the groundwork for a big asset price boom with big rate decreases.

The last thing many investors want is a permanent increase in interest rates, which is what we are having. A big long term permanent change also means a big long term permanent change in investments, particularly in bonds and real estate.

So, How Do We Trade This?

For the most part, we shouldn’t. Fear of recession or fear of big problems for our stock market because Japan has decided to raise interest rates are misplaced – and temporary. They are not fundamental risks like rising interest rates or big decreases in government stimulus.

Other fundamental factors, such as corporate profit growth are looking good, with S&P 500 companies showing an 11.5% increase in earnings in the second quarter.

Market Got Ahead of Itself – Up 20% by early July – Whoa!

I think what’s really going on in the broader picture is that the market got ahead of itself in early July and is pulling back. If we annualized the 20% increase we had by early July, we would be seeing an increase of 40% in the S&P 500 this year after a very good 2023. That seems unlikely.

Also, when the market gets ahead of itself and corrects, the correction may snowball. The reality is that, despite all the problems in July, the S&P 500 ended up ½%.

The same could happen in August.

Focus on Key Macro Trends and Long-Term Dramatic Outperformance of the S&P 500 to Make Money in These Markets

I feel the best and safest way to make money in the market is to perform well above the S&P 500 over the long term. That means ignoring short term movements heavily driven by short term psychology and focusing on the key macro factors affecting the markets and the economy longer term.

That’s not how you should pick stocks, but I have found few investors who can pick stocks that greatly outperform the S&P 500. Same for short term market timers. I wish them all the best, but as for me, I think that it is too risky and will not yield anywhere

near the long term profits that my strategy creates.