What a few days it’s been for stocks!

The great value rotation levitating high-yield blue chips like British American (BTI) and small caps in recent weeks has suddenly given way to a new narrative: Recession.

The great rotation has given way to margin calls at hedge funds selling anything that’s up in recent weeks.

What Hedge Fund Margin Call Forced Selling Can Do

That kind of forced selling can take 25% off even dividend aristocrats like Realty Income (O) and dividend kings like Lowe’s (LOW).

The peak decline for this pullback was 6.5% as of Friday.

Japanese stocks suffered their biggest-ever daily loss Monday as fears about a US economic slowdown sent shock waves through global markets.

The Nikkei 225 index of leading stocks in Tokyo lost a staggering 4,451 points, its biggest drop inhistory. The index closed more than 12%, taking its losses from early July to 25% and entering bear market territory.

“That was a crash. It smelled like 1987,” Neil Newman, head of strategy at Astris Advisory in Tokyo, told CNN. He referred to “Black Monday” in October 1987, when global markets plunged, and the Nikkei lost 3,836 points.” – CNN

The Japanese stock market has fallen over 25% in three days. As far as I know, this is the fastest any large global stock market has fallen 25% in international history.

Lenin’s famous quote feels very apt in 2024, when we’ve seen seismic political events occur every week.

But allow me to paraphrase Mr. Lenin ironically. “In the stock market, there are years when nothing happens and days when it feels like years happen.”

Monday is one of those days.

Pre-market S&P futures are down almost 4%, and the Nasdaq is down over 5%, wiping out $1.4 trillion in market cap in one day, and that’s just for the Nasdaq.

The US stock market is down $2.5 trillion today.

Individual stocks? They can be down even more.

While there is news about NVDA (I’ll discuss it in a moment), there is no fundamental reason for Amazon, already trading at 12X cash flow with a PEG of less than 0.5, to be down 8%.

BTI? There is no news to justify a 6% decline. Value, high-yield, hyper-growth, it doesn’t matter today. Everything is getting sold because it’s a global margin call for hedge funds.

If you think cheap overseas markets like Europe are doing better, not really. The sell-off is global.

Stock market volatility has risen from 13 on the VIX on July 16 to 42 by Monday morning.

It soared to 53 a few hours later as the global margin call accelerated, and the S&P hit as low as 4.5% pre-market.

Why Is This Happening? Global Margin Call For Hedge Funds

Like on March 16th, 2020, global hedge funds are getting margin calls. But that was when the market was down almost 30%, and right now, the market is down just 9%.

What’s going on?!

It’s hedge fund margin calls.

The Yen has rallied faster than ever. 162 to 142 (down is up for Yen).

That’s created massive margin calls for hedge funds that were massively short the Yen. Like how managed futures were shorting bonds for two years, hedge funds shorted the hell out of the Yen when it hit 36-year lows. And now, suddenly, a recession scare in the US, US rates crash, and the dollar vs the Yen implodes. Catching huge Wall Street money is completely off-side. Thus, everything has massive sell-offs, from growth to value to Mag 7.

The Reversal of The Carry Trade: The Match That Lit The Gasoline Soaked Rag

Being long, the Dollar/Yen was the carry trade for the last two years.

And here’s why.

When you hold dollars, you earn over 5% risk-free, the T-bill yield.

When you are long the Dollar/Yen, you are short the Yen, the funding source.

In other words, you borrow in Yen and buy dollars, earning a risk-free 5%.

For years, the interest rates in Japan have been negative.

That means that even when US rates were very low, you could still earn free money (the spread) in dollars/yen.

And when US rates went from 0% to 5.25%?

The Dollar/Yen “carry trade” profitability exploded to close to 5.5%.

Even without leverage, you could earn 5.5%, and hedge funds, of course, used leverage. Why?

The most common strategy for hedge funds is trend following, and when US rates rise, you can earn free money by shorting the yen; that’s what they did.

The Yen weakened for two years to the lowest level in 36 years.

Like trend-following hedge funds (managed futures) made out like bandits during the worst bond bear market in US history by shorting bonds, Carry trade was a gold mine.

Futures usually require about 10% margin, so you can theoretically use futures on the Dollar/Yen of 10X.

Imagine going 10X long the dollar/yen and earning over 50% yield, and as the yen falls, you will earn profits on top.

Imagine being 10X levered risk-free cash and earning Buffett-like annual returns by doing it.

Of course, no hedge funds use that kind of high leverage because if the Yen weakens any amount, you get a margin call.

However, some hedge funds used 2X leverage, others used 3X, and some even used 5X.

When the Yen rallies 13% in a matter of days, anyone with 7.5X or higher leverage in the carry trade gets a margin call.

And have to unwind their positions quickly.

That is why this hedge fund margin call is happening this early into a correction when stocks have yet to fall 10%.

It’s A Perfect Storm of Pessimism

It’s rare that a single reason, even algo selling due to a hedge fund margin call, can cause the stock market to decline by almost 5%.

Global risk-off on pickup in growth worries following last week’s softer-than-expected July nonfarm payrolls and ISM manufacturing prints.

The continued unwinding of the yen exacerbated the weakness in carry trades following last week’s BoJ rate hike.

The continued unwinding of stretched systematic longs is another overhang. The ongoing ramp in AI scrutiny (FT, Bloomberg, FT, Bloomberg), Middle East tensions (Axios), US political uncertainty, and negative seasonality are some recent bearish talking points.

The selloff triggered talk about the Fed being behind the curve and speculating an inter-meeting Fed rate cut. Street also highlights expectations for a more aggressive Fed over the next few meetings. Some thoughts on the negative takeaways from the July employment report were overdone, given the hurricane impact and other dynamics (Reuters).” – FactSet

OK, now that you know why the market fell almost 5% on Monday, let’s look at the three dangerous ideas you need to avoid during this sell-off.

What About Recession Risk?

You might have recently heard much about the Sahm rule, just like the yield curve inversion made headlines in October 2022.

Take the lowest U3 unemployment rate (headline rate) of the last 12 months.

Now look at the three-month rolling average.

If three-month unemployment is 0.5% above the 12-month low, the economy is likely in recession.

The Sahm Rule has been triggered, but even Claudia Sahm says that we’re not likely to be in recession.

Q2 GDP came in at 2.8%, and the NY Fed had previously expected similar growth in Q3.

Job growth has been at 170,000 monthly for the last three months.

We had similar job numbers in April as we did in March 2022.

The average unemployment rate since WWII is 5.7%.

The current rolling average on job creation is similar to late 2023.

The US economy grew around 3%, 1% faster than the long-term trend rate economists expect in 2025 and 2026.

Growth is expected to slow in Q3 and Q4, but bottom around 1.5% before slowly recovering to trend of 1.8%.

In other words, the US economy grew 1% faster than the trend and is now back to trend, i.e., “normal” long-term growth rates.

Yield Curve UnInversion:

• The yield curve between 2s/10s un-inverts for the first time in over two years

Yes, uninversion typically signals recession is close to or has already started.

However, that’s because a positive sloping yield curve is normal long-term. The curve can’t be inverted forever, and so either the economy goes into recession, and the Fed cuts short-term rates so they fall below long-term rates, or long-term rates can rise (due to lack of recession) in a bear steepening.

Right now, the bond market is very bearish on short-term rates.

But let me point out something very important. The bond market thinks the Fed will rapidly cut 2% to 3% by June 2025.

That’s the bond market’s long-term expectation for long-term Fed funds.

In a recession, does the Fed cut the long-term normal rate? Or does the Fed cut below-average long-term levels to stimulate the economy?

The bond market is currently pricing in NO RECESSION in 2025.

Moody’s estimates a 33% probability of recession in the next year.

Economic data is consistent with 2% growth, not a recession.

Since each index began, financial stress indexes have used zero as the average financial stress.

St. Louis Fed Financial Stress Index (STLFSI)

The STLFSI tracks 18 weekly data series to measure financial stress:

• Interest Rate Spreads: Includes various spreads such as the TED, commercial paper, and corporate bond spreads.
• Yield Spreads: Includes the 10-year Treasury minus the 3-month Treasury spread.
• Volatility Measures: Includes the VIX (equity market volatility) and the Merrill Lynch Bond Market Volatility Index.
• Other Indicators include the S&P 500 Financials Index and the Chicago Board Options Exchange (CBOE) Market Volatility Index.

Kansas City Fed Financial Stress Index (KCFSI)

The KCFSI uses 11 monthly data series:

• Yield Spreads: Includes the 2-year Treasury minus 3-month Treasury spread and the 10-year Treasury minus 3-month Treasury spread.
• Interest Rate Spreads: Includes the TED spread and commercial paper spread.
• Volatility Measures: Includes the VIX and the high-yield bond spread.
• Other Indicators include the S&P 500 Financials Index and the Kansas City Financial Stress Index.

Chicago Fed National Financial Conditions Index (NFCI)

The NFCI tracks over 100 indicators, categorized into three main subcategories:

• Risk: Includes measures of volatility, credit spreads, and leverage.
• Credit: Includes measures of borrowing costs, credit availability, and credit conditions.
• Leverage: Includes debt levels and leverage ratios in the financial sector.

These three financial stress indexes use over 119 metrics that look into every part of the financial system.

The adjusted NFCI was able to predict the Great Recession.

2001 was the mildest recession in US history, with a 0.3% peak decline in GDP.

The Great Recession was the worst financial crisis since the Depression and the 2nd most severe recession since WWII.

Peak GDP Declines In Every Recession Since 1920

Whenever these indexes are all negative, the US has never been in recession.

In other words, below-average financial stress has never been recorded if the economy was contracting.

Could this be the first time? Yes. Unprecedented things happen all the time in the world.

But is there a chance that we’re secretly in some severe recession, the kind the doomsday prophets warn about?

Over 119 financial metrics indicate that the doomsday prophets are wrong.

While nothing is 100% on Wall Street, I can promise that if a severe recession comes, we’ll see it in the data and give ample warning.

Bottom Line: Wall Street Is A Complex, That’s Why Even Experts Are Surprised On Days Like Today

No one knows why the market does anything on any given day or short-term period.

We can make educated guesses, hypotheses, and plausible-sounding explanations, and usually, we’re partially correct.

But the market comprises every investor, trader, speculator, and algo.

Just like we can’t know why Buffett sold 50% of Apple, we can’t know exactly why the S&P is down 3% today, and the VIX has almost tripled in three days.

Here is what I can tell you right now.

Panic is starting to grip the market. Even my lizard brain feels terror, while my logical mind is excited about buying opportunities.

Why aren’t value stocks rallying like they did on Thursday and Friday? Because of margin calls.

Big hedge funds must sell something when they get margin calls due to crashing tech holdings (Softbank Masayoshi San is down over $3 billion today alone).

Anything that’s up recently represents the obvious choice for forced selling.

That’s why BTI is down 4% in one day on zero news.

Since everyone is focused on Buffett, how about his most famous quote, “Be greedy when others are fearful.”

Investors are now the most afraid they’ve been in the last year.

Some arguments that the snap reaction following the latest growth scare may be overdone include the July payroll weakness driven by a spike in weather-related and temporary layoffs, which is expected to reverse in August.

There is a rise in the unemployment rate due to new/returning entrantsrather than rising layoffs, while prime-age EPOP is the highest since Apr-2000, annualized wage growth is still at YTD trends. Earnings remain resilient, with Q2 EPS growth of 11.5%, the highest since Q4-21, and acceleration in upwards earnings revisions (Earnings Insight).

High-frequency data suggest still-strong consumer impulse, including restaurant bookings, TSA air travel data, and credit card spending. New York Fed’s Q3 GDP Nowcast also dented 0.6pp following last week’s negative ISM payrolls surprises, though it continues to run at a 2.1% pace. Last week’s selloff was also relatively orderly, with resilience in some pockets, including defensive.

Also, some support from the Fed put (market pricing 97% chance of 50 bp September cut, 122 bp of cuts by year-end), M&A revival (FT), and reopening of buyback window.” – FactSet

In other words, the sell-off is overblown and driven to extremes by forces selling by algos and hedge funds during their carry trade margin calls.

I can’t tell you whether this panic selling is over. The carry trade, triggered by falling US interest rates, may worsen in the short term.

Maybe big tech will become the favorite hunting ground of short sellers, at least in the short term.

But I can tell you that with the US economy’s fundamentals still solid and big tech’s earnings, specifically and the S&P’s in general, still expected to be double-digits through the end of 2026 (and 2027, according to Goldman, due to AI’s effects on the economy), this sharp sell-off is a glorious opportunity for long-term investors.

As the late great Charlie Munger said, “invert, always invert.”

“Oh my God, NVIDIA is down 35% in 3 weeks!” should be a call of joy because it allows you to scoop up shares at highly attractive valuations.

NVDA is now 22% undervalued and was as much as 30% undervalued at Monday’s lows.

Hyper-growth Amazon is more than 50% undervalued after rallying 5% off the day’s lows. It is trading at 12X cash flow while growing cash flows by 30% through 2029 and free cash flow by 646% in Q2.

And suppose you’re not comfortable with growth stock valuations. In that case, you can buy extraordinary high-yield aristocrats like ENB or BTI at single-digit multiples, even after impressive rallies in recent weeks.

The principles of smart long-term investing never change, even on scary days like today.