Stocks have recovered from the sell-off, at least for now

From today’s weekly overview of financial market developments, it all ended well. In the end, some indices even ended up slightly positive for the week, but the stormy events at the beginning of the week will not be forgotten for some time. The Tokyo Nikkei plunged as much as 12% (but recovered all the losses by the weekend), and the New York index fell about 3% on Monday, marking the third consecutive day of highs falling. The Tokyo stock market fell more than 20% from its peak in a short period of time (theoretically, entering a bearish trend), while the New York S&P 500 opened the week almost 10% lower than the highest point reached less than a month ago. Let’s look at some of the reasons why the stock indices fell so quickly and sharply from their historical peaks.

Carry trade becomes less attractive
The reason for Tokyo’s “hara-kiri” may be mainly due to the abandonment of strategy Arbitrage TradingAfter the Bank of Japan raised interest rates a week ago (to 0.25 percentage points), the yen has been clearly stronger for some time amid the central bank’s tightening policy. Arbitrage Trading It has long been popular with larger investors, but the key is that they borrow money in a country with low interest rates (Japan is ideal – interest rates have been almost zero for a long time), and then they look for investment opportunities in other countries with low interest rates or in countries with high interest rates (such as the United States). But as said, things are changing. Japan is tightening rates, the United States will start reducing rates in September, and the yen is already strengthening. In short, Arbitrage Trading Not so attractive anymore. Maybe some big funds’ plans went awry when the yen rose and they got calls for additional hedge positions (Margin Call), they were forced to sell when the stock price continued to fall. The avalanche was triggered, and too many sellers exited at the same time, so the move was even stronger during the August holiday.

US economic recession?
Even before the infamous August 5, the negative trend in developed stock markets was already evident, as we reported last Sunday. Analysts mostly attributed the downward revision to the deterioration of US macroeconomic data. The news from the labor market and the increase in the unemployment rate to 4.3% (the highest level in nearly three years) was particularly stinging. There were concerns that a recession was imminent and that the US central bank had delayed cutting interest rates for too long. Such concerns were somewhat overblown, but after GDP grew by 2.8% (annualized) in the second quarter, economic growth is likely to slow in the second half of the year. The data released on Thursday showing a decrease in unemployment benefit applications (from 250,000 in the previous week to 233,000) proved that the situation in the labor market is not always worse. This triggered a strong rebound on Wall Street, with the S&P 500 rising 2.3%, the biggest gain since November 2022.

The market is ripe for a correction
With global stock markets (excluding China) rising strongly over the past year and a half, it is time for them to fall. Goldman Sachs warned (when the index was still at record levels) that the gains of stocks compared to bonds have been unjustified for some time, amid the increasing risk of a bad scenario. The numbers speak for themselves: the New York S&P 500 index has risen 70% since hitting a multi-year low in 2022, and the market value of the 500 stocks that make up the index has risen by nearly 80% since the beginning of 2020, doubling its share of US GDP. According to many standards, stocks (mainly American) are overvalued, which is also shown by the Shiller P/E ratio indicator, which takes into account stock prices and inflation-adjusted earnings over the past decade. His value has reached 36, which is well above the average (17). Historically, this indicator has only gone higher twice (at the peak of the bubble in Internet companies at the turn of the century and in 2021), and both times it occurred after a sharp decline in stocks.

Too high expectations about UI
New highs and records on the New York Stock Exchange are mainly associated with the performance of stocks of large technology companies, which are now sharply down. For example, Nvidia shares opened on Monday already 35% below their all-time high, but are still nearly twice their year-to-date high. The chip developer’s quarterly results will not be released until August 28, and the bar is very high in the sector, as evidenced by the sharp drop in AMD shares on Thursday (they are now more than 50%) due to falling profit margins. The mania related to artificial intelligence is clearly waning, and many large companies have spent billions of dollars to avoid missing the UI train, but the results of massive investments still need to wait. Investors are impatient, so they are eager to cash in on the brilliant profits.

Remaining risk factors
There are also some risk factors that should not be ignored, which do not have a significant impact on trading at present, but may have a significant impact in the future. Geopolitical tensions in Ukraine and the Middle East have not eased at all, but have intensified. Tariff wars, especially between the United States and China, are taking on new dimensions, and things may become more complicated with the victory of Donald Trump in the US election. The threat of fiscal irregularities or high debt in the United States has also long hung over financial markets. Recently, the debt broke through the $35 trillion (35 trillion) mark, which already means 123% of GDP. In short, there are quite a few flash points that could trigger another crisis, but at least for now, the stock market has emerged from the selling vortex.