Volatility has returned on Wall Street and it's affecting Main Street. While a little over a week ago markets were relatively calm and orderly, things have changed - and so has our outlook.
This week's musings are inspired by the 1987 film "Wall Street." The film is loosely based on the junk bond and insider trading scandals of the 1980s. Here's some trivia about the film:
The film performed moderately well at the box office, grossing more than $43 million on a $15 million budget. In the financial world especially, the film has become somewhat of a "cult classic" as so many of the lines are quotable.
Michael Douglas won an Oscar for "Best Actor" for his portrayal of Gordon Gekko - his only acting Academy Award nomination.
This film had a first associated with it - it was the first film to feature a cellular phone.
Tom Cruise wanted the role of Bud Scott, but Oliver Stone had already given the role to Charlie Sheen.
The famous speech by Gordon Gekko where he says "greed is good" inspired the working title for the film, "Greed," until Stone ultimately changed the title.
Daryl Hannah was uncomfortable with the role of Darian, Bud's girlfriend, and there was tension between her and Sean Young, who plays Gekko's wife. Young wanted the role of Darian and she constantly reminded Stone of her desire to play the role. Young did not get along with most of the cast & crew. She regularly showed up late and unprepared for shoots. At one point, Sheen stuck a piece of paper on Young's back with a derogatory name on it. No one pointed it out to her.
The famous "greed is good" speech:
"The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA."
Here's what we've seen so far this week..
Wall Street Broken? Let me be clear, I don't think it's time to hit the panic button. However, markets experience events prior to recessions that I like to call, "warm ups." If you've ever watched two teams, whether it's baseball, football, or basketball, warm up before a game, you can see a difference in the two teams that could play out on the field during the real game. That's what the last few trading sessions have been like.
This all started with the "carry trade." That's probably something you've heard a lot about over the past week. Put simply, the "carry trade" was about cheap rates and margin. From 2016 to 2024, interest rates in Japan have been in the negative range. Investors have been able to borrow Yen at negative or near zero interest rates, convert to Dollars, then buy securities on margin.
That worked just fine while Japanese interest rates were low and U.S. securities were rising. However, in March the Bank of Japan (BOJ) raised rates from -0.1% to +0.1%. Not a big deal at the time, because margin rates were low and equities were still rising. However, on Tuesday of last week, the BOJ raised rates another +0.25%, at the same time, the Fed signaled a potential rate cut for later this month. That would equate to a potential 75 basis point swing in interest rates between Japan and the U.S. This sparked margin calls on Yen "carry trades" which caused institutional investors to sell U.S. securities (and other global securities) to meet margin calls.
However, a weaker than expected Jobs number on Friday of last week sparked fears of a potential recession while the "carry trades" on Yen were unwinding.
J.P. Morgan says that approximately 75% of the "carry trade" has already been unwound. Who knows? Going forward, however, individual economic data points will be carefully watched as markets are jittery. Meanwhile, the Fed is in a quandary. The market now shows only a 53% probability of a 50 basis points rate cut later this month and a 47% probability of at least a 25 basis point rate cut. However, if the Fed does that, it could affect markets even further on the downside if the "carry trade" on Yen is not fully unwound by the next Fed meeting.
On Monday of this week, more unwinding of the "carry trade" occurred, forcing the VIX higher. In fact, the intraday high for the VIX reached 65.7. Although it settled back down to 38.5 by the end of the day, the intraday swing was the highest on record for the VIX (nearly double the previous intraday swing record). As previously stated, these events are typically "warm ups" for something yet to come. The team that drops the ball in warmups or struggles to shoot the ball in warmups might not be able to overcome their opponent when the real game starts.
Greed Is Good? Gekko was right when he said greed is good, but only from the standpoint of motivation and hard work. We work hard to take care of ourselves and/or our families. Without motivation, we stagnate. However, greed isn't so good when it clouds our investing judgment.
Several signs have begun to emerge that suggest something (i.e., a recession) may be brewing beneath the surface. The Yield Curve (10yr Treasury Yield minus 2yr Treasury Yield) has been inverted for a record 525 days. The yields of the 10yr Treasury and the 2yr Treasury are now just a few basis points away from each other, when just 3 weeks ago they were more than 30 basis points apart. Why is this important? When the curve uninverts or returns to normal, it typically means that recession is near. On average, once the Yield Curve normalizes or uninverts, a bear market begins within 129 days. Each yield curve normalization and bear market is different, so it's anyone's guess how it may play out this time, but it's something that investors need to plan for in the future.
On the economic front, one of the largest contributors to GDP, other than the consumer, is government spending. We saw government spending rebound in the last quarter of 2023, but so far this year, it has dropped by 6% year-over-year. This could lead to more pressure on the economy if the consumer does not step up in a major way.
Another way of looking at government economic activity is the Fed. For the past few years, the Fed has been actively involved in overnight liquidity through Reverse Repo operations. We covered Reverse Repos in a blog post about a 2 years ago. The amount of Reverse Repos started to decline in March of last year. The level of overnight Reverse Repos is down to about 11% of the amount of activity as the peak in 2022. In addition, the number of counterparties is down from 116 at the peak to 52 (a 3-year low) as of Wednesday night.
Another sign of economic stability being disrupted, along with liquidity, is a credit crunch. Beginning late last week into early this week, the ICE BofA US High Yield Option-adjusted Spread Index increased more than 30% over a 3-day period. While it's not quite on the level as previous recessions, it still should raise one's eyebrows. Prior to the 2000, 2008, and 2020 recessions, the index rose 153%, 98%, and 223%, respectively. This should harken us back to the idea of are we witnessing a "warm up" of what may be to come?
So - what should investors do now? Just to be clear, our indicator is not recommending raising cash at this point in time. However, investors can rebalance and adjust to life after the Fed begins to cut interest rates. For those who still have considerable gains in high momentum stocks (i.e., Mag 7 and AI), now might be a good time to consider rotating to asset classes that are likely to out-perform after a rate cut - if history repeats. For example, after previous rate cuts, Utilities, Communication Services, Staples, Health Care, & Financials tend to out-perform. I should caveat that statement by stating that the Communication Services sector has changed since 2019, and now includes Google, Meta, & Netflix, which are also part of the Mag 7. By contrast, Industrials, Materials, Consumer Discretionary and Energy tend to under-perform. Again, cash isn't necessarily something investors should be keen on raising today as a defensive measure, but as markets settle down, taking profits in one sector in order to rotate to another sector might not be a bad idea.
The master of greed, Gordon Gekko...
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