hey everyone it's Richard you're watching the plane Bagel. if you're someone who follows the markets you might have noticed that things hit a bit of a speed bump this past weekend to put it lightly with the S&P 500 falling nearly 8% from its August High to a trough over just a couple of days and the NASDAQ a tech heavy us index uh actually entering correction territory meaning that its index had fallen by at least 10% from its recent high. and it wasn't just US Stocks taking a hit here in Japan we saw the Nic a 225 index fall 12% just on Friday. it's biggest single day drop since Black Monday of 1987. and even Bitcoin which many would hope is more uh removed from these traditional markets so its own price fall from over $64,000 at the end of July to at one point dipping below $50,000. uh later recovering some of that lost ground with the whole Affair amounting to trillions of dollars ultimately being wiped from the global

stock market over just a couple of days. And as you can imagine, seeing the sort of volatility over such a short period of time, as you can see here with the VIX Index, which measures stock market volatility or how much prices are moving around. It's led to a lot of fear and concern. 2024 year today has been a very strong year for markets, but people have been bracing for The elusive recession, given that interest rates are very high at the moment, and that tends to be followed by a period of economic contraction, with many people arguing over the weekend that this is it, this is the big one, the unraveling of the market, with a lot of Doom posting and flaming pictures and thumbnails really coming back into fashion for a hot minute, which is why I want to post today's video. Not to downplay the real risks that do exist in the economy, of say, a recession coming up, but to try and combat some of the more extreme stuff out there, because these type of

events can be really concerning or scary for investors, especially those starting off. Um, and my goal today is to go through some of the proposed reasons as to why we saw this sudden dip in the markets and to explain and demystify them a little bit. Uh, but to also try and put things in perspective without sensationalizing stuff. So, in today's video, I'll try to demystify all this, explain what happened, what the Som rule is, why people keep bringing up Japan with all this, and again try to provide some perspective on things. So, what is it that happened over the weekend to cause this sudden drop in markets? Well, the truth is we don't actually know with 100% certainty. Don't worry, that's not the end of the video. I will go over some of the proposed reasons, uh, but with these types of events, we can't actually know with certainty what's driving the selloff in markets. We have things that have correlated to the sell-off that make sense as an explanation, but it is

difficult to describe market behavior using just a handful of factors. It's near impossible to know with certainty what's causing everyone in the market to sell at a specific time. That being said, there are sort of three main reasons that have come forward as likely contributing to the sell-off we've seen, with the first being the Federal Reserve decision last week to hold interest rates at their target range of 5.25% to 5.5%. As you know, the Federal Reserve has been on a campaign over the past couple of years to fight inflation using higher interest rates, and while inflation has come down from its peak from two years ago, it's remained pretty stubbornly around 3% for the past year. This, despite rates being at the highest level we've seen in over two decades. And because of this, the Federal Reserve has been delaying its rate cuts. Many had expected that we would have already seen a rate cut by now, but with the most recent inflation figures again while pointing to an improved inflation rate.

still showing a higher figure. The Federal Reserve decided last Wednesday to keep rates at their current high level, which wasn't necessarily unexpected, but many do fear that this restrictive Economic Policy, which again has been going on for longer than expected, is entering the territory of Overkill, and that it might hamper economic growth. Given that higher interest rates tend to dampen economic activity, which can explain why they can help reduce inflation when it's demand-driven, but it can likewise cause a recession, because, again, it's lowering activity, it's discouraging spending and borrowing, and they can have a Leed impact on the economy. So as Ray Cuts get pushed further and further into the calendar year, many expect that it will take even longer after that point to actually impact and help bolster the economy, which at that point might be too late to avoid a hard Landing or a recession, and there are concerns that things are a little stretched debt to GDP for the US government is relatively high and stock

valuations, as measured by the CAPE ratio, are near the high end of their historical range, meaning that there's some room for downside there. So that's kind of the first domino here that's been highlighted by some as contributing to this sudden selloff over the weekend. The Federal Reserve decision not to cut rates, pushing a possible rate cut to September unless we see an emergency rate cut happened in the meantime. The second main factor being highlighted was disappointing US Labor data that was posted on Friday, which is again pointing to a cooling economy. With the report showing that unemployment had risen to 4.3%, a three-year high, and the economy had only added 114,000 non-farm payroll jobs, which is actually down roughly 36% from the previous month and was 35% lower than forecasts. Now, by itself, an unemployment rate of 4.3% probably doesn't sound all that concerning. In fact, compared to other developed countries, it's actually on the low end. But the reason why some are highlighting

this as one of the causes of the selloff is that this new unemployment data actually triggered. What's called the Som rule uh, which if you've never heard of the Som indicator before, it simply measures the difference between the current 3-month average of the unemployment rate uh, versus the lowest 3-month average over the past year. And when this indicator or difference is above 0.5%, it is said to indicate that we have started a recession. And when you graph the indicator versus past recessions, which you can see with the gray areas here, you can see that there is a strong correlation between the two. So some took this to mean that that elusive recession that we've been somehow avoiding for the past little while is now upon us. And it does follow other disappointing figures that again point to a somewhat cooling economy in the United States, including the purchasing managers index dropping to 46.8% in June. With any level below 50% being considered weak or contractionary. And with us being in the middle of earning season, we've also seen

a lot of the big tech companies, especially in the space of AI, uh, either reporting disappointing or just lackluster results or guidance, uh, including the likes of Google, Microsoft, and Amazon, companies that importantly have been big drivers of stock market performance over the past year. With most notably Intel stock falling over 20% after announcing itself that it was going to be carrying out sizable layoffs. With this actually being part of a bigger Trend, we've seen with layoffs in the tech space, this despite kind of the continued optimism around artificial intelligence, with many taking that as a sign that the growth we were expecting in the space is not actually materializing. So those are the first two reasons, and as you can tell, they both have to do with the possibility or fear that the US might enter a recession over the next 12 months or so, uh, with many Traders or investors looking to get ahead of that by selling early. The third reason, however, which many have highlighted as the main trigger of the selloff, actually has nothing to do with

the possibility of a US recession, but is more of a technical issue that Traders have seemingly run into, and that is the Japanese carry trade, the term that you've probably, if you follow content online, seen brought up endlessly over the past week or so. Now again, if you've never heard of a Japanese carry trade, and you're confused why Japan is being brought up when talking about a US stock market decline, again, don't worry, you're not alone. I'll walk through why this is being proposed as sort of the main trigger here, but to do so, we do have to give a bit of context as to what the country of Japan is currently going through. For the past while, Japan's currency, the Yen, has been fighting against a declining exchange rate against the United States dollar, meaning that it's becoming more and more expensive to buy US Dollars, and as a result, imports and other US dollar-denominated things, with the value of the Yen actually dropping to its lowest level against the US dollar since the 1980s.

with a big reason for this decline being the fact that while the rest of the developed world has hiked interest rates to try and fight inflation. Japan has actually kept their rates near zero to actually bolster inflation since the country uh with its Asian demographic traffic and low consumer demand has actually experienced periods of deflation and is using this aggressive monetary policy to try and kickstart demand in the economy and help trigger wage growth. But because of this big discrepancy in interest rates some investors and traders have looked to take advantage of that and carry out this thing known as the carry trade uh where they effectively borrow in Yen uh paying this low interest rate on the loan they take uh convert that money into something like the US dollar and then invest in US assets like treasuries or stocks with the idea being that you can earn the difference interest rates between the low interest rate that you're paying in Japan and the higher interest rate you're earning in the US assuming that you hold exchange rates.

constant. But therein lies the rub, you see, year to date, this carry trade has been profitable for investors because the Yen has continued to fall in value, with it dropping nearly 13.3% year-to-date before the recent events. This being good for investors who carry out this trade because when they do sell their US investments and try to convert back to Yen to pay back their loan, they'll actually end up with more Yen than they would have otherwise because of that exchange rate change. But on Wednesday last week, the Bank of Japan actually increased its key interest rate to about 0.25% from a range of roughly 0 to 0.1%. And while not a meaningful change, it did buck the trend of the falling Yen exchange rate, with the currency actually rising over 10% from its low in July. Which is bad for investors who are in this carry trade because all of a sudden their loans that are denominated in Yen have become 10% more expensive to pay off. And so because this trade became

less profitable. The rise in the Yen's value led to a massive unwinding of these Yen-based carry trades, with investors selling their US assets, converting the funds back into the Yen, and then using the proceeds to pay back the Yen loans, which will also have a negative impact on Japanese markets. This is something that could help explain why we've seen a decline in US stock prices, with James Malcolm, a Japan macro strategist at UBS, estimating in a note to clients that there was roughly $500 billion in this carry trade at its peak. Now we've seen an estimated $200 billion of this amount being unwound over the last 2 to 3 weeks, which leaves another $300 billion of estimated money in this carry trade that could be further unwound if the Yen continues to appreciate in value. But it's unclear if we'd see the full amount reversed even if we did see that changing exchange rate, so definitely a more obscure and complicated factor, but something with seemingly a good amount of firing.

power behind it that could help to explain why we saw the hiccup. We did it's definitely led to a lot of pessimism not just within the stock market but for the overall economy. Oil prices fell from the high 70 to the low $70 range uh with dropping oil prices usually indicative of an expectation that there's going to be lower demand given that oil is such a broadly used commodity within the economy. Bond yields also fell with a 10-year treasury yield dropping below 4% recently something that usually means investors are selling other assets to park funds within bonds uh which increases the price and lowers their yield uh because they expect a recession or other turmoil ahead and they're looking for a safer investment to hold in the near term. And of course you might have seen the news that even Warren Buffett himself recently sold off a bunch of Apple position with Burkshire hathway currently sitting on a record $277 billion of cash which might lead you to believe that if Warren Buffett is doing it surely the the rest of us

should too uh but outside the fact that Burkshire has highlighted some of this selling activity to be tax related there are a few things to consider before you just sell it all. For one, as we've highlighted many times in this channel, it's near impossible to predict when recessions will occur even with these indicators with a seemingly strong track record. For example, we've had other indicators like the inverse yield curve that have been triggered in the past that haven't always been followed by a recession. And even if you could accurately predict when recessions will occur, stock markets aren't perfectly correlated to the economy, so that wouldn't even necessarily translate into information you can use to outperform the stock market. It's also why you shouldn't take stock market performance to be predictive of what the economy will do in the near term. And as an extension of that, while labor stats have certainly been disappointing, we do have other factors that point to a strong US economy at this time, such as the

current consumer demand. And on Monday, we did have top officials from the Federal Reserve come out to reassure markets that America is not in a recession. Heck, even Claudia S, who is The Economist who created the S rule that supposedly triggered a bunch of the sell-off, has even herself come out to say that, No one should be in panic mode today, with her citing growing household income, resilient consumer spending, and business investment. Which to that last point, while some are concerned about the AI boom fizzling out and certainly expectations around earnings will be tough to meet, it is still worth mentioning that tech companies are still spending pretty heavily in developing the space. Capital expenditure, for example, which is the amount of money that companies are investing in equipment, property, and other things like that to try and support their business growth, is still very high for the companies in the AI space. And in fact, that is in part a contributor to why guidance has been disappointing as companies are increasing the costs and the amount of money they're spending.

the economy to try and intensively develop their AI. Secondly, it's always helpful to zoom out, and it's worth emphasizing here the fact that despite the sell-off, uh, this decline has really just tapered off some of the excess return the indices have experienced, with the S&P 500 still being up over 10% year-to-date, well above its long-term annual average. And even the Nikkei 225, which was hit harder by the turmoil, remains up roughly 5% so far into the year. So while obviously things might continue to fall further from here, characterizing this as a crash sort of hides the fact that markets are still up by a healthy amount for the year. And finally, well, certainly not something that's going to fix everything, uh, you do have to keep in mind that the Federal Reserve, the government, and other authorities of that sort are actively trying to lessen the impact of a recession and could at any point announce, uh, whether it be an emergency rate cut or some other stimulus to try.

and fight off any decline we might see. And while we wouldn't likely see this sort of intervention just because markets sold off a little bit, it does go to show why recessions, again, are very difficult to predict. Because not only do you have to look at how the economy is currently performing, try to predict where it's going to be in the future, but we also have to try and forecast the decisions of the key market players like the central bank and the government. So with everything we've covered, is a recession coming? Maybe. Could stocks drop lower? I don't know, yeah, I guess. But that's kind of the point I'm trying to get to here. Certainly, there is the possibility we enter a recession in the near-term. There is sort of elevated risk of that, but it's worth considering that recessions are a recurring phenomenon in the economy. And despite past crises, corrections, and recessions, the stock market has managed to earn a strong long-term return for investors. For most people, rather than trying to time these

sort of events and risking that you might miss out some of the days of strong performance. Uh, that you're usually better served to just focus on that long-term performance. Uh, and just trying to ensure that you're not taking on excessive risk and that you're being prudent with your portfolio. So all this video hopefully helped to explain what things like the Japanese carry trade and the S rule are, and they are interesting to dive into for most long-term investors. They don't matter a whole lot, which is why I kept that till the end of the video 'cause I need the views anyway. Hopefully this helped to explain some of the volatility we've seen. It's not to argue that we're not going to enter recession. There is certainly elevated risk that we might see a contraction in the near-term. It's just to argue that no one knows what's going to happen both on the positive and the negative side of that kind of spectrum, so you shouldn't put too much weight on someone's prediction about where markets or the

economy are going to go from here. Uh, anyway, that's the video. Thank you for joining me today. If you like this video, found it was helpful, uh, please do make sure to like, subscribe, all that good stuff. It does help the channel tremendously. And let me know your thoughts on all this stuff, the possibility of a crash, or what we saw over this past weekend in the comments down below. Uh, thanks again for joining me today, and as always, be safe out there.

The $6.4T Stock Drop - Why Is Everything Down?

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I'm a CFA and CFP professional working as an analyst for an investment management company in Ottawa. I'm a huge finance nerd and am passionate about the field - I think people lack the resources they need to make educated financial decisions, and hopefully this channel helps with that!

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The videos on this channel are for education purposes only and do not constitute financial advice. Richard Coffin does not provide recommendations on The Plain Bagel - those looking for investment advice should seek out a registered professional. Richard is not responsible for investment actions taken by viewers and his content should not be used as a basis for investment trades.