A sense of calm has returned to Wall Street.
But it hasn’t been easy.
To recap for those whipsawed by the fast and furious action: Rising recession risks and the rapid unwinding of yen carry trades sent stocks into a tailspin on Monday. Fast forward to Friday, and the S&P 500 (^GSPC) finished the week with its best two-day gain of the year. The CBOE Volatility Index (^VIX), the market’s fear gauge index, closed the week at 20.37, just above its long run mean. That’s a far cry from its spike above 65 on Monday, a level that’s typically associated with panic and fear.
Yes, the recovery in markets is encouraging, but investors shouldn’t jump to the conclusion that we’re in the clear. Instead, proceed with caution as top Wall Street strategists tell me we’re not out of the woods yet.
“The churn will probably continue through September or October, until the November elections,” veteran investment strategist Ed Yardeni told me on Yahoo Finance’s Morning Brief.
Yardeni attributed much of the volatility to the unwinding of the yen carry trade. The trade — where investors borrow at near-zero interest rates in the Japanese currency then put the proceeds into higher yielding assets like US stocks — is contingent on low Japanese interest rate and stable currency value.
When that doesn’t happen, the trade can blow up, which happened on Monday. A rate hike by the Bank of Japan caused the Yen to spike in value, triggering sell-offs to cover those loans and fears of a broader de-risking.
“Much of what we saw was a short covering situation,” Yardeni explained. “A lot of this was centered in Japan, and looking ahead, I think we’re going to see the market continue to churn below the July 16 high.”
UBS’s Solita Marcelli points out that market volatility could remain “elevated” for some time, due to thinner liquidity over the summer, a further unwind of the yen carry trade, uncertainty surrounding Fed policy, and the upcoming presidential election.
Continued volatility may also be driven by economic data prints.
Stuart Kaiser, Citi’s head of US equity trading strategy, told me markets are “on edge” as investors look to inflation and jobs reports for reassurance.
“The positioning part of [the selloff] seems to have calmed down a little bit, but the data part is going to be ongoing,” Kaiser explained. “It’s going to take a little time for things to calm down and get people reengaged.”
Thursday’s large rally following weaker than expected jobless claims underscores just how skittish the market is about the risk of a recession.
Wells Fargo investment president Darrell Cronk described the jobless claims induced rally as “unusual,” and further evidence the market is “balancing on a hairpin.”
Analysis by DataTrek found that when the VIX closes at 35.3 or higher, future S&P 500 returns average 2.4% over the next month and 6.9% over the next 3 months. As of Friday’s close, the S&P 500 had already rebounded 3% from Monday.
“While we hope for further gains over the next three weeks, history says to keep our expectations modest,” DataTrek co-founder Nicholas Colas wrote in a note to clients.
“Current market conditions are not comfortable, to say the least. But … They are neither flashing a robust recession warning nor condemning the current bull market to a premature end. After a rough week, we take comfort in that message,” Colas added.
To sum it up: Investors should prepare for more ups and downs but remain optimistic as the market navigates this uncertain period. After all, research from Goldman Sachs’s David Kostin found that investors typically profit when buying the S&P 500 following a 5% selloff. Since 1980, the S&P has generated a median return of 6% over the following three months, with positive returns 84% of the time.
Hard to argue with data going back almost 45 years.
