Market Pulse
Monday, August 12, 2024
Welcome to this week's Market Pulse, your 5-minute update on key market news and events, with takeaways and insights from the Sidekick Investment Team.
Our three stories this week:
It’s important to note that the content of this Market Pulse is based on current public information which we consider to be reliable and accurate. It represents Sidekick’s view only and does not represent investment advice - investors should not take decisions to trade based on this information.
Global stocks experienced a sharp sell-off last week on the back of disappointing U.S. labour market data. Two Fridays ago’s labour report, which featured rising unemployment and weak job creation, indicates that a soft landing for the U.S. economy may not be on the cards after all. Indeed, based on the 'Sahm rule,' a heuristic which judges recession risks based on labour market strength, an economic slowdown could already be in progress. [1]
Last Monday, the S&P 500 posted its worst day in about two years, falling around 3%. [2] Tech-heavy indexes like the Nasdaq struggled even more. But the volatility was far from just an American phenomenon, with European, British, and Asian markets posting drawdowns as well. [3] Notably, the Topix index in Japan experienced its worst day since the 1987 crash. [4]
In fact, Japan’s experience provides a case study for the risks (and opportunities) stemming from global monetary policy changes in the near future. Frustrated by the declining yen, which makes imports more expensive, the Japanese Central Bank decided to raise interest rates last week – even as the rest of the world launches a global cutting cycle. [5]
This hike proved to be a rude wake-up call for traders employing the 'carry trade.' The carry trade involves borrowing cheaply in a low-rate currency (like the yen) to invest in riskier assets denominated in a higher-rate currency (like the dollar). [6] For the past few years, the riskier assets on the long side of this trade have commonly been Big Tech stocks in the U.S., helping fuel some of Magnificent 7’s stunning growth. [7]
With Japanese interest rates rising last week though, the carry trade has lost some of its economic appeal. Carry traders unwinding their positions in response likely explains at least some of the market volatility we’ve seen on both sides of the Pacific.
Although the rising yen has been tumultuous for carry traders, the move has largely benefited our Flagship portfolio. The performance, in GBP, of our currency unhedged holdings in defensive Japanese companies like Kao and KDDI should benefit from a strengthening yen. In addition, our defensive overall positioning relative to our benchmark (including higher cash holdings) has proved beneficial during the most recent sell-off.
While the VIX index (commonly known as Wall Street’s 'fear gauge') briefly climbed above 60 on Monday, it has since fallen to levels in the 20s. Although that’s still an elevated reading for the VIX, you can forgive investors for being anxious after the turmoil of this past week. We’ll finish off with what we believe to be a very relevant quote from Peter Lynch: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
The 60/40 portfolio is a classic asset allocation rule of thumb that recommends a default blend of 60% stocks and 40% bonds for investors. The basic logic of the 60/40 is simple. Because bonds tend to do well when stocks do poorly (and vice versa), it makes sense to have a sizable allocation to each asset class. The historical outperformance of stocks, though, means it should constitute a larger piece of the portfolio.
This logic breaks down, though, when stocks and bonds begin to move in tandem. While the performance of the two asset classes has mostly been negatively correlated since 2000 (as measured by the return of the S&P 500 and U.S. Treasuries), this relationship began to reverse around 2020. [8] Post-Covid, the correlation between stocks and bonds has largely shifted into positive territory.
This regime change proved disastrous for most 60/40 portfolios, which could no longer rely on the strong performance of one asset class when the other did poorly. In 2022, the classic 60/40 portfolio posted its worst annual return since the 1930s, leading at least some asset managers to wonder if this rule of thumb was dead. [9] [10]
Rumours of the death of 60/40, though, now appear to be greatly exaggerated. Amidst the market dislocations of the past few weeks, bonds once again returned to their classic position as a defensive asset. After peaking on July 16th, the SPY ETF, which tracks the S&P 500, has fallen by about 8%. Over the same period, the USIG ETF, which tracks a broad index of investment-grade US corporate bonds, has eked out a small positive return.
As the logic of the 60/40 portfolio shows, bonds returning to their traditional position as a safe haven asset isn’t just good news for fixed income investors. This dynamic also allows diversified investors to feel more comfortable holding riskier assets like equities, confident that the defensive portion of their portfolio will serve its purpose during challenging periods.
Leveraged ETFs have been growing in popularity over the past few years, with the launch of new products designed to provide 2x or 3x the returns of entire sectors (like semiconductor or AI companies) or specific stocks (like Nvidia or Tesla). Despite a brief slowdown in 2023, the popularity of these funds has surged in 2024, with net inflows nearing record highs. [11]
As the name suggests, leveraged ETFs use leverage (in the form of margin or derivatives) to amplify the returns of the underlying asset. When the price of the underlying asset booms, investors can realise outsized returns. But when prices decline, as they have over the past week, leverage magnifies the downside, leading some of these ETFs to post losses of 60% or more. [12]
While leverage’s role in amplifying risks and rewards is well-known, less appreciated is the impact of the so-called ‘volatility drag’ on leveraged investments. [13] Simply put, it’s relatively harder to recover from a big loss than it is a small one. A 10% loss needs just a 11.11% gain to return a portfolio to its original value. A 30% loss, though, needs a 42.9% gain.
Aside from their impact on individual investor portfolios, the performance of leveraged ETFs might also be impacting the market as a whole. If margin calls force leveraged fund managers to sell holdings in the underlying assets, they can contribute to the type of market dislocations we saw last week and intensify sell-offs.
Our Flagship portfolio does not employ leverage and has no plans to implement leveraged investments in the future. In our view, while leveraged ETFs might make sense for some strategies, the downside risks remain poorly understood by many retail investors.
Note: Our Flagship Portfolio contains Nvidia and Tesla
[1] Bloomberg
[2] Bloomberg
[3] The FT
[4] The FT
[5] New York Times
[6] The Economist
[7] Axios
[8] AQR
[10] Goldman Sachs
[11] The FT
[12] Bloomberg
[13] Kitces
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Please remember, investing should be viewed as longer term. Your capital is at risk — the value of investments can go up and down, and you may get back less than you put in.
