Japanese stocks' single-day drop hits a new record. Is it time to buy the dip?
2024-08-06
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(The author of this article is Xia Chun, Chief Economist of Hong Kong Founder Financial Holdings)
On Monday, the Nikkei index fell 12.4%, wiping out 14 months of gains in one day and returning to the level of late May and early June last year. Moreover, this was the Nikkei's largest single-day drop in history.
You should know that since the establishment of the Nasdaq Index, the largest one-day decline was only 12.3%, which occurred during the impact of the epidemic in 2020. The S&P has only experienced a larger decline once, which occurred on "Black Monday" on October 19, 1987.
Today, global investors encountered another "Black Monday".
Everyone will say that the sharp drop in Japanese stocks is closely related to the reversal of the yen carry trade and the change of the yen from depreciation to appreciation. But few people answer a key question. At the end of 2022, the yen rebounded by 16%, and at the end of 2023, it rebounded by 7%. Although the Nikkei index also fell back at that time, the amplitude was very limited. Recently, the yen has only appreciated by 13%. Why did the Japanese stock market pullback so sharply?
It turns out that the main institution engaged in carry trading is Japan Overseas Insurance Company. Although carry trading is simple and effective to make money, it does involve exchange rate risk, so insurance companies will take measures to hedge exchange rate risks, mainly through forward contracts, currency swaps and put option transactions.
The earnings reports of Japan's nine largest life insurance companies as of March 31 this year showed that as much as 47% of these companies' overseas securities were covered by hedge derivatives.
However, this figure is actually the lowest level since September 2011, and the peak was as high as 63% in March 2020. As the yen continued to depreciate against the dollar before July, these insurance companies are likely to have further reduced their hedge ratios, betting that the yen will continue to depreciate against the dollar.
However, the reality went against expectations. Starting from July, the uncertainty of the US election and capital market increased significantly. Institutions that lent yen asked investors to reduce their yen positions. The yen strengthened against the US dollar, catching these insurance companies that lacked sufficient exchange rate risk hedging and suffered losses off guard.
Now, these overseas insurance companies need to buy yen to repay them, and the yen may appreciate to around 130. Therefore, the yen appreciation may reach 20%-25%, which is significantly higher than the end of 2022 and the end of 2023. This will greatly affect Japanese listed companies that are highly dependent on overseas income. Since shorting the yen and going long on Japanese stocks are the most crowded trades, this led to a plunge in the Japanese stock market on Monday.
The Nikkei has fallen 25% from its highest point this year in just 17 trading days. Historically, the Nikkei has fallen by more than 20% only four times in such a short period of time, in 1990, 2008, 2013, and 2020. However, the maximum decline in these four times within three weeks was only 23%, which shows how fierce the recent decline is.
From a trading perspective, instead of buying Japanese stocks now in the hope of a short-term rebound, it is better to continue to watch the trend of the yen. The market now believes that the Federal Reserve may suddenly announce an early rate cut. I have explained in previous videos that this kind of rescue-type rate cut is very helpful to the stock market.
As of last Friday, the S&P and Nasdaq have retreated 6% and 11% from their highs, respectively. In my recent video, I predicted the trend of the US stock market in advance and gave clear reasons.
Regarding the U.S. stock market, there are two diametrically opposed views in the market. One view is that the U.S. stock market will continue to plummet, repeating the bursting of the Internet bubble in 2000 and the financial crisis in 2008. The other view is that there is no obvious bubble in the U.S. stock market, and listed companies have good profits. As long as the Federal Reserve decisively cuts interest rates, they will hit new highs by the end of the year.
I offer four points for your reference. First, the current decline in US stocks is completely normal. According to historical data from 1928 to 2023, the probability of the S&P index falling by more than 10%, 15% and 20% this year is as high as 64%, 40% and 26% respectively.
From 1980 to 2023, the average maximum retracement of U.S. stocks from their annual highs was 14.2%, so there is no need to be surprised by the current 6% drop in the S&P.
Second, the stock market also saw an extremely rare anomaly from 2023 to 2024, where the daily ups and downs were almost all between -2% and 2%.
The last time this happened was in 2017, when 99% of global asset prices rose. I believe that the extremely optimistic market sentiment has created a once-in-a-century low volatility market, which will not be sustained in 2018 and the stock market will plummet.
As expected, 93% of global assets fell in 2018, and a once-in-a-century market trend appeared again.
Third, using the earnings of listed companies to judge the medium- to long-term trend of the stock market is helpful, but not very useful in the short term.
Because the biggest challenge facing the market now is the "crowding crisis", that is, the most concentrated long-tech giants and short-yen trading reversal, and everyone is escaping when a fire breaks out.
The biggest impact on the stock market is the mutual reinforcement of the deterioration of liquidity in the market and financing. When people step on each other, the market liquidity will be insufficient. Successful transactions will require high costs. In order to protect their own interests, financial institutions as intermediaries will require borrowers to reduce leverage or cut off financing, thus forming a vicious circle. In fact, the essential logic of each market crash is the same.
Fourth, although interest rate cuts are theoretically beneficial to the stock market, they are almost always a precursor to a recession. Once coupled with excessive market concentration or potential crisis, interest rate cuts will not be able to prevent the market from falling.
After the United States cut interest rates in 2000 and 2007, U.S. stocks continued to fall.
Judging from the rising unemployment rate, the US economy has most likely entered a recession, which will aggravate the crisis facing commercial real estate. Although it is not as serious as the residential real estate crisis in 2007, the market may not pay enough attention to it.
Another crisis that has not been fully priced in by the market is the life-and-death battle between the two parties in the US general election.
On the whole, I still recommend that you be cautious, reduce the proportion of allocation to stocks that have seen large increases in the past, and increase the proportion of allocation to defensive sectors such as consumer staples, healthcare, utilities, government bonds, gold and other assets. In fact, the performance of these assets in the recent period has been relatively ideal.
Of course, this black swan event also tells us that it is far more important to make good strategic and tactical allocation of assets than to focus on one track. If you want to cross the bull and bear markets, you need to make multi-track and multi-variety allocations. Only by withstanding the decline can you rise better.
This article only reflects the author’s views.
