Last Friday we highlighted the 6% fall in Japan that day, and this was followed by a 12% collapse on Monday. Inevitably this is our focus today. What happened? Is it important? Do you need to take action?
Two weeks ago I wondered how the media would respond when the markets fell 10% in one day, as they were using up their lexicon of apocalyptic adjectives with falls of 1-2%. This week they got their chance, as the Japanese stock market, the Nikkei 225, fell by more than 12%. Yet most coverage, fed by knee jerk reactions from within our industry, missed the point.
On Tuesday the FT headline was “Fears over US recession drive sell-off”. With all due respect, that is tosh.
It was a “flash crash”. Conveniently, we had a pre-planned meeting of our Investment Committee at 8.30am on Monday, and a 12.4% overnight collapse certainly gave it some added colour. Without very much reflection we were clear it was a flash crash in Japan. There is no strict definition but it is essentially a fast and deep fall in financial markets, where prices quickly steady and begin to rebound. This is how the day progressed UK time:
- The Nikkei closed at 7am our time, down 12.4%.
- The Nikkei ETF traded in London opened at 8am our time, and was soon down 9%, mostly mirroring what had happened in Japan overnight.
- By the close in London at 4.30pm, it was only down a little over 1%.
- Over the last 5 days, from Monday, the iShares Nikkei 225 is up 1.7%.
But what triggered the sharp falls in Japan?
No media coverage was complete without apportioning blame, where events in the US were the favourite bogeymen. Let’s take a look:
- US job numbers. Wrong. On 26th July I gave short shrift to those stating that the unfolding jobless numbers in the US meant that US recession was “a certainty”. They were relying on something called the “Sahm Rule”, and you might have seen reference to this in recent days. A few points are worth making. It is only a rule of thumb, and in any case the Rule wasn’t hit, not quite. Perhaps most damning, the economist after whom it was named, Claudia Sahm, doesn’t believe the US is in recession. She believes there is enough risk to cut interest rates, which is a completely different matter.
- US recession risk. Wrong. If you dismiss the Sahm Rule, there is very little else to dictate that a recession worthy of the name lies just ahead. There is a lot of data, sufficient to allow the Fed to cut rates, but not enough to trigger a recession panic, and definitely not one that would have any substantive relevance for Japan.
- AI bubble bursting. Wrong. The small number of mega US stocks that have soared this year buoyed by AI fantasies have little relevance to Japan. And these stocks, the Magnificent 7, peaked a number of weeks ago.
- Carry trade. Hmmm. The carry trade means investors borrow very cheaply in Japanese yen, and then invest that money into an investment in a different currency e.g. European corporate bonds, non-Japanese government bonds, non-Japanese stock markets. Some might have borrowed in Japanese yen, and invested into Japan, but that is a different matter, and not a carry trade.
- Yen rising. Aha.. Many invested into the Nikkei 225 index because it was full of global exporters who were big beneficiaries of the multi-year weakness in the yen. Interest rates didn’t go up much (see note last week) but it was sufficient for a sharp recovery in the yen, making much of the Nikkei 225 less attractive – but nowhere near enough to justify a 12% fall on Monday. Something else was needed…
- Yen interest rates up. We’re getting there. The strengthening yen combined with the higher interest rates certainly acted to amplify the risks. But which risk?...
…The risk which comes with complacent, over-confident, and over-exposed investors. The flash crash risk. The stampede risk. The risk of torschlusspanik, literally door-shut-panic, as these investors realise they are in deep trouble. Here is why…
It was reasonably well understood that during the course of 2024 the Nikkei had attracted buyers, and a significant number were geared.
For example, they had borrowed money to buy into a market which seemed certain to keep going up – the weak yen would keep buoying the share prices of the big exporters which dominate the Nikkei. My guess is that in coming weeks it will become clearer how many professional investors and institutions had played this game. But it had been documented for some months that Japan’s army of retail investors had piled in, to the tune of $30 billion according to a report on Bloomberg in June.
Imagine you had £1,000, and you could borrow £10,000 to invest into the “certain” profits available in your home stock market. This is gearing of 10-to-1, meaning your gains are magnified by 10. Exciting stuff.
For example, if the market goes up 5% you make £500 of profit on your £10,000 investment – which is 50% gain on your outlay of £1,000. But it can and does goes wrong, and it did on Monday for those geared Japanese investors.
When the Japanese market was down 10%, that was a loss of £1,000 on the £10,000 invested – more importantly, that original £1,000 stake is completely gone. A 100% loss.
It can quickly get much worse. If the market fell 20% the loss is £2,000, twice as great as the original stake - a personal loss of 200%.
It can get catastrophically worse. If you bought a futures contract you might have gearing of 20-1. Your loss in the latter example is now 400%. This is the very nasty impact of gearing.
You get the picture.
The yen had fallen so far that when the Japanese central bank made a very small change in their interest rates last week it had a disproportionate impact in turning the yen around and up. This in turn undermined the single biggest plank to speculate in the Nikkei index – the weak yen. Geared investors in the Nikkei had to sell very fast to cut losses which were escalating rapidly.
It was a stampede to get out.
Because these extremely exposed investors got out fast it meant that conditions quickly normalised during Monday in Western markets, as you saw bulletted at the beginning of this note. That is why it was a flash crash – rapid decline, followed by a quick normalisation and turnaround.
If we are wrong, we will know reasonably quickly, we will revisit the implications of the last week.
But for now there is no need to panic about Japan. There were very rapid and sharp falls because over-excited and complacent investors borrowed money to invest, or used derivatives to achieve that gearing. They have been quickly cleared out.
The irony in all of this is that Japan is one of the most stable places to invest in the world, perhaps the most conservative choice amongst major stock markets. Valuations are inexpensive and it is politically stable.
As an aside, having said that this was nothing to do with the so-called “carry trade”, the risks associated with the carry trade are very much alive and kicking, and are global in nature as we set out last week:
“With rates near zero, global and Japanese investors borrowed vast sums extremely cheaply in yen, to buy a range of investments around the world, from higher yielding European bonds to US tech. The problem is that when Japanese interest rates go up, those investors will want to repay the loans – which means selling the investments which they bought with those borrowed funds. There is no evidence of this happening yet, and it will not be easy to spot in real-time, but we must be very wary of this risk.”
Vast sums were borrowed in this way. Hang on to your hats.
Returning to the events of this week, do you need to take any action? Some retail investors did act on Monday, and there was a bit of a panic, evidenced by some investment platforms being unable to cope with the volume of selling.
Whether you should act depends on your personal investment plan. For example, the vast majority of those trying to sell on Monday were not applying a planned stop-loss – this was mostly fear. How you felt on Monday, and how you acted, tells you much about how you are likely to respond in the future.
There will be much worse days, and perhaps its greatest value was to remind investors about risk.
Frustration with the last few years of investing is one thing. But addressing the possibility of substantial and sustained losses across much of your portfolio is quite another mental challenge.
The frustration is justified. As of Monday, the FTSE World Index ex US had gone precisely nowhere for three years. Zilch.
If you add in the US, the gain was 15%. By adding back in the US, this represents 62% of the index in a stock market where the historical precedents are clear on the downside – say 50-75% for the sake of argument. That 15% was made with the benefit of hindsight, and you can’t buy hindsight. On the other hand, to ignore history (this time is different?) would be foolish.
Hopefully next week will be a bit quieter! Already we are seeing professional investors bargain hunting in Japan.