For the first time since the middle of October, stocks are careening lower. The NYSE Composite Index is threatening to break back below its 200-day moving average. Fear is on the rise, with the CBOE Volatility Index (VIX) back above its 50-day moving average. Treasury bonds are rising on safe haven inflows. And gold and silver are on the move.
To understand why this is happening, you have to understand the context for the market's rise over the last two years. Despite a stalling of global GDP growth and modest profit growth here at home, the flow of cheap money stimulus and the rise of popular and lucrative currency carry trades have won the day.
Much of the recent gains we've seen here in the U.S. have been driven by so-called multiple expansion: It's not that companies are earning a lot more but that investors are willing to pay more for them. You can see this in the swelling of the S&P 500's price-to-earnings multiple. The cyclically-adjusted price-to-earning multiple, as calculated by Yale economist Robert Shiller, has increased from 20.9 in November 2012 to 26.5 at the end of last month — a level that's only been exceeded during the run ups to the 1929, 2000, and 2007 market tops.
A primary motivator behind all this has been the collapse in the Japanese yen, as Tokyo, fighting years of a debt-deflation nightmare, went all in on money printing as a way to try to inflate its way out of trouble. Japan’s central bank has undertaken quantitative easing writ large, buying up stocks as well as bonds. And it’s crushed the yen, which is down more than 36 percent since late 2012, when this experiment began.
That's provided smooth, easy currency carry trade gains to hedge funds and other institutional traders, who borrow in and take a short position against the weakening yen and buy into a strengthening currency (the dollar) via stocks and bonds denominated in that stronger currency. As long as the yen keeps weakening against the dollar, it provides extra capital with which to buy stocks.
The trade has become so profitable — and automated, thanks to the rise of computer trading algorithms — that the U.S. stock market pretty much follows the yen-dollar cross exchange rate on a tick-for-tick basis these days.
That pattern is being thrown for a loop this week as the yen carry trade turns lower on weakness in the dollar and strength in the yen. The reversal hasn't been severe, but the response to any movement in the wrong direction is magnified by the popularity of the trade and the amount of leverage being applied to it.
The turn has been driven by a deeper-than-expected 1.9 percent annualized contraction in Japan's economy during third quarter, following a 6.7 percent decline in the second quarter, in response to a sales tax hike from 5 percent to 8 percent in April. The return to recession is calling into question the tenability of Japan's position, between a 227 percent public debt-to-GDP ratio, stagnant growth, and now, the realization that a weaker currency isn't the panacea many believed it would be, especially with higher costs pinching consumers.
Also weighing on sentiment is a possible political crisis in Greece that could lead to a general election and the elevation of anti-bailout politicians (resulting in the worst one-day selloff for Greek stocks since 1987), efforts in China to contain a surge of stock market speculation following an interest rate cut there, and ongoing weakness in the junk bond market here at home as fixed-income traders prepare for the approach of the Federal Reserve's first interest rate hike since 2006 sometime next year. On top of all that, with no budget deal in place in Washington yet, we cannot completely dismiss the possibility of another government shutdown either.
Should stocks reconnect with where long-term Treasury bond yields are — which have remained low over the last two months in a sign bond traders didn't share the enthusiasm reflected in the stock market — the S&P 500 could very well return to its mid-October lows. That would be a 9 percent decline from current levels.
Back on October 16, a day after stocks bottomed, I wrote that a rebound was likely given how oversold stocks had become. The rally we've since then has gone far beyond my expectations. But now, with trouble mounting, it's time to get defensive again.
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