This morning, a reader asked a very heart-of-the-matter question for any stock market investor–are there any signs of recession that I see? My answer:

–I tend to be an optimist, so I may not be the best person to ask

–historically, the most important leading indicator for the state of the US economy is the US stock market. Yes, we’ve had a sharp selloff recently, the second so far this year, but the S&P 500 is still up by about 14% ytd in 2024, with the Nasdaq lagging that a bit. So I’d count that as a positive sign

–monetary policy remains restrictive, as the Fed attempts to counter pandemic-era stimulus. In other words, the monetary authority thinks the domestic economy is still running a bit too hot, not too cold. Also, the Fed is most likely going to lower short-term interest rates soon, adding stimulus for the domestic economy

–I read the market selloff as an issue about valuation rather than a sign that earnings are about to deteriorate

–on the (to my mind) negative side: food prices remain elevated; US consumers who rotated down to lower-priced stores for everyday merchandise during the recession (from supermarkets to Walmart, from Walmart to dollar stores, from dollar stores to companies not publicly traded (btw, I own shares of WMT, TGT and CASY)) as they usually do… haven’t rotated back up in the way they have in the past when times get better; and the recent implosion of the yen carry trade underlines the possibility for further unrevealed ugliness in private equity, the banks and hedge funds

–we can see the general lack of dynamism in the domestic economy through the Russell 2000 index of smaller-cap stocks, whose constituents are overwhelmingly geared to the domestic economy. Over the past ten years, it has risen 1.8x. In contrast, the S&P is ahead by 2.7x and the Nasdaq by 4x. Half or more of the profits of the latter two come from outside the US. So the negative I just cited may merely be the results of the anti-growth policies of today’s MAGA Republicans.

I’ve just published my July 2024 Keeping Score, with an addendum for the opening days of August. Ex IT and Communication Services, cyclically-sensitive stocks remain stronger than would be the case if the market were really worried about recession.

That’s what the CIO (my boss’s boss’s boss) as I was making the transition from securities analyst to full-time portfolio manager in the mid-1980s said most often. His second favorite remark was not to waste time on the +10% ideas. Concentrate on finding the +30% and +50%s. (I’d modify that by saying that once you’d found the latter, it’s ok to fool around with the former. It’s like batting or fielding practice–it keeps your head in the game.)

During the first half of 2024, NASDAQ gained +25%. The S&P peaked a couple of weeks later at close to +20%. Both would be fabulous results for just about any full year. Easy to say in hindsight, but these numbers themselves argue that, for a while at least, sideways would be the best one could hope for …and sideways almost never happens. So a drift down was in/on the cards. Actually, that was the best case scenario.

We got that for a while, but then the bottom dropped out with a sharp lurch downward yesterday.

the carry trade

The carry trade is a form of arbitrage, the “carry” being the income gained from holding a position minus the cost of doing so. For some time, the most straightforward strategy has been to borrow (or sell short) in Japanese yen and use the proceeds to buy US Treasury bonds. The yield on the Japanese bonds you short is about 1%; the 10-year Treasury is around 3.8%. So if nothing changes, you pick up a “free” 2.8% or so.

Although bond to bond is the simplest arbitrage, you can also do something more complex, like shorting a Japanese stock index or individual stocks or the yen and buying some other mix of currency/index/stocks.

Japan is the ideal thing to short, because the country has been an economic disaster for more than three decades (following an anti-woman, anti-immigrant, anti-foreigner, anti-men with hair on their faces, pro-samurai policy, grounded in the idea of Japan’s uniquely favorable relationship with the divine, that sounds eerily like the MAGA platform here), So while there would be the chance of a gain from long Treasuries as the Fed lowers short rates, if form runs true there should be little chance of an economic pulse in the Land of Wa.

the practitioners: the banks …and private equity?

In my view, the masters of currency-related trading are the international banks. I always thought of myself as part of the dumb money in the currency arena, although I’d really like my chances if the main competition were private equity. My guess is that private equity was the trigger for the ructions of the past two days.

what happened?

There seems to have been a mass liquidation of long $US-, short yen-related arbitrage positions. The trigger was the Japanese central bank raising short rates from zero to 0.25%. I don’t know, but I find it hard to believe that this had any dramatic effect on major international bank positioning (I don’t include Japanese banks in this category). This leaves computers and relative amateurs as the culprits.

where to from here?

Who knows? I’m often (always?) too optimistic, but my idea is that this is that forced selling from yesterday washed a significant amount of speculation out of global markets. If so, this is a time to look for babies thrown out with the bath water, in what will likely be a sideways market.

I don’t have much desire to add to my tech exposure, which is already pretty significant. I’m shopping for steady growth, a reasonable PE and maybe even a dividend yield instead–downtrodden value stocks, in other words. I’m a little surprised that I’m doing this, but it’s what I find most attractive at the moment.