Market Rollercoaster: What Happened This Week#

Here’s the lowdown on the wild market swings we’ve seen.

First, the crash:

• On Monday, August 6th, 2024:
  • The S&P 500 opened down almost 3.5%.
  • The NASDAQ was down 4%.
  • Other Global markets were down significantly more.
    • The Nikkei 225 (Japan) was down over 12%.
    • Taiwan’s Main Stock Index had its worst day in history.
• This followed a trend over the preceding week where trillions of dollars were wiped off markets worldwide.

Then, the finger-pointing:

• Everyone was looking for someone to blame.
• Common targets included Japan, the Fed, and greedy Wall Street Traders.
• Basically, “whoever else people want to blame when things go wrong”.

The confusion:

• Just to show that nobody fully understands what’s really going on…
• …just one day later (Tuesday), markets across the world rallied.
• This rally almost covered the losses from Monday.

Naming the day:

• People are already calling Monday’s crash the New Black Monday.
• Expect a lot of YouTube thumbnails featuring:
  • Red graphs.
  • Laser eyes.
  • “So so many flames”.

So, the big question is: What the is happening to the stock market right now?

• European and Asian markets were plummeting around the world.
• Futures were being watched, showing they were more than a thousand points down.
• Traders were advised to “put on their hard hats” because US markets picked up where Japan left off.
• The global stock market intensified its fall.
• The MK index fell 12%, described as the single worst decline since the 1987 crash on Black Monday.
• Markets in London, Washington, and Mexico were mentioned in this context.

Understanding the Selloff: The Theory of Reflexivity#

To get a handle on why this might be happening, you should probably know about a concept pioneered by a famous investor.

• This concept comes from George Soros.
• Soros is a polarizing figure, but regardless of how you feel about him, he’s considered one of the greatest investors and hedge fund managers of all time.
• He credits his success to a theory he came up with called Reflexivity.
• (A link to his full lectures, books, and papers on the mathematical modeling of his theory would be provided, but that level of technical detail isn’t needed to grasp the current situation).

In simple terms, for capital markets, Reflexivity says:

• Markets can be explained by feedback loops.
• These feedback loops distort asset prices away from what their true fundamental value should be.
• Eventually, a spark causes prices to revert back to an equilibrium.

Pundits of this theory also point out:

• Positive feedback loops (the ones that push prices up into a speculative mania) tend to be long and drawn out.
• The reversal of those feedback loops (the crash) tends to be very quick.
• This sounds a lot like what markets are experiencing right now.

The Setup: AI Hype and Stretched Valuations#

One argument you could make is that the market has been caught in a positive feedback loop.

• Hype around artificial intelligence (AI) and its potential uses has massively boosted the value of just a few companies.
• Five or six already extremely large companies have seen their value catapulted into the trillions.
• Most other companies have been trading completely flat.
• But just the Magnificent Seven (as they’ve been dubbed) have effectively carried the entire stock market because of their sheer size and price performance.
• This extra investor money flowing into these companies has funded intense research and development in AI.
• This R&D accelerates progress, meaning almost every week you see some new technology that could potentially make jobs redundant.

Fueling the loop:

• This feedback loop has also been helped along by trillions of dollars worth of liquid capital accumulated globally.
• This led to stretched valuations as investors piled in, not wanting to miss out (“don’t want to be left out of the party”).

Signs of slowing down:

• This trend was already starting to slow down.
• Investors were becoming weary about whether these companies could ever justify their high valuations.
• Consumers were starting to show resistance to AI tools.
• About a year ago, tools like ChatGPT and MidJourney were seen as incredibly exciting by consumers, professionals, and even college students with overdue assignments.
• Now, a recent study revealed that consumers intentionally don’t purchase goods or services that openly feature AI.
• This was putting pressure on the bubble.
• But, like the theory says, the fire still needed a spark.

The Spark: Japan and the Carry Trade#

Everybody is blaming this global market crash on Japan and a “weird little investing loophole” made possible by their unusual economy. It’s time to understand a bit about how money works to see why this is happening now.

Here’s the background on Japan’s economy and the setup:

• Japan’s economy has been stagnant for more than three decades.
• The Japanese government and its Central Bank (Bank of Japan) have tried to fix this by keeping interest rates extremely low.
• Rates were even negative between January 2016 and January 2024.
• The hope was that low rates would encourage borrowing within Japan and boost the economy.
• But this didn’t really happen.
• The Bank of Japan became almost stuck with these low rates because raising them would slow down their already sluggish market even more.

How investors took advantage (The Carry Trade):

• These low Japanese rates didn’t do much for Japan’s economy, but investors saw an opportunity.
• They would borrow money in Japanese Yen at these low rates.
• Then, they would either invest it in Japan or, more often, exchange the Yen for another currency (like the US dollar).
• They would then invest that money in asset markets elsewhere, like in America (assuming “stocks only ever go up”).
• Investors could make money on the spread between the low Japanese interest rates they paid for the loan and the higher returns they got from their investments.

The scale of the carry trade:

• According to data from the Bank of International Settlements, the total value of these cross-border loans (the carry trade positions) was more than $1.5 trillion.

An added bonus for carry traders:

• This investing scheme was made even better because the Yen was dropping in value relative to the US dollar.
• This meant investors could make extra money on the foreign exchange exposure if they didn’t protect against currency swings (hedge against it).

The Reversal: The Yen’s Swing and the Market Crash#

Like all good things, the carry trade “worked well until it didn’t.”

• Eventually, the value of the Japanese Yen got too low.
• This prompted the Bank of Japan to change course and raise interest rates.
• The new rate is a “staggering” 0.25%. (Note: This is still extremely low compared to rates in most other markets).
• This move caused the value of the Yen to increase by more than 11.5% in just under a month.

The impact on the carry trade:

• Such a rapid swing in the exchange rate between two of the most traded currencies in the world (first and third most traded) sent shock waves through the financial system.
• Investors who had borrowed in Yen for the carry trade now faced double-digit losses in just a month, purely due to the Foreign Exchange losses on their loans.

Let’s look at an example:

• Imagine you had $100,000 of your own money.
• Last month, you borrowed $900,000 worth of Japanese Yen.
• You used this to take out a 10-to-1 leverage position (meaning you controlled $1 million worth of assets) in American markets.
• Because the Yen you borrowed has appreciated in value significantly…
• …the Yen debt you owe is now worth more than a million dollars in dollar terms.
• In this scenario, you would have lost all of your money ($100k principal gone, and you still owe more than you invested).

The chain reaction:

• This situation is forcing many investors to close their positions (sell assets) to cover their suddenly much larger loans.
• This selling is pushing markets down around the world.
• The selling also pushes the value of the Yen further up (as they sell assets in other currencies and buy Yen back to repay loans).
• As markets lose value, other investors see their positions falling and panic sell.
• This forces more people to sell.
• Ultimately, this cascading effect meant the losses on Monday alone ended up being greater than the total value of all the carry trade loans in existence.

Connecting back to Reflexivity:

• Following the theory of Reflexivity, this carry trade unwind acted as the “spark”.
• It’s effectively taking the “easy money” out of the feedback loop that was driving markets higher.
• This happened right as the hype around the most valuable companies (AI stocks) was already starting to decrease.

Uncertainty ahead:

• Things are changing so quickly that by the time a video on this topic is published, markets might have fully recovered.
• Or, “we could be in 2008 all over again.”

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(This section was originally placed here in the text)

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What Does This All Mean for You?#

Okay, let’s talk about what this market chaos means for you personally.

First, a key reminder:

• It’s a good time to remember that the stock market is not the economy, and the economy is not the stock market.
• For example, today, after the “New Black Monday,” markets rallied and almost fully recovered their losses.

However, a word of caution:

• There’s danger in putting too much hope in this quick recovery.
• People who are paid millions of dollars to manage billions are not sure what this situation is either.

Looking at history:

• Two of the top 10 best trading days in the history of the Dow Jones Industrial Average happened in 2008.
• Another one occurred in 1929.
• Both of these instances were in the lead-up to major crises: the global financial crisis and the Great Depression, respectively. Good market days can happen even as things are heading south long-term.

Wealth and asset ownership today:

• According to data from the St. Louis Fed:
  • The top 1% of individuals now own 34% of all financial assets.
  • This is an accumulation that has never been higher.
  • This is despite fintech advances like commission-free trading apps (Robin Hood was mentioned later) and fractional shares designed to make investing more accessible to everyone.
  • Simultaneously, the share of financial assets owned by the bottom 50% of individuals is now only 2.6%.
• Yes, that’s “depressing”.

Problem 1: It’s not just rich people who get hurt.

• You might think, “This market crash is only going to hurt rich people. My investments can’t tank if I never had any investments, right?”
• Wrong.
• According to the Financial Times, several retail brokerages experienced issues.
• Platforms like Charles Schwab, Vanguard, and Fidelity had outages.
• Robin Hood actually halted trading during the selloff.
• This affected regular people who were trying to sell their positions.
• Many smaller, less sophisticated investors were selling off the few investments they had out of fear that this could be the start of a recession they think is overdue.
• This situation is only made worse by alarming headlines and YouTube thumbnails with laser eyes competing for clicks by highlighting how bad things could get.

Problem 2: The economy isn’t completely separate.

• The anecdote about the stock market not being the economy is only half true.
• If the stock market is doing very well, there’s no guarantee that widespread economic well-being will follow for everyone.
• BUT, if the stock market is doing badly, companies will face pressure to pull back on expenses, especially things like Staffing, to keep shareholders happy.
• Big Tech layoffs are already happening.
• Laying off generally high-income earners can have a multiplying effect as they reduce their own spending at local businesses.

Personal Guidance: Don’t Panic Based on Generic Advice#

The most important thing you can do individually right now:

• DO NOT take any advice from people on the internet.
• This applies no matter if they claim to be a financial professional or former financial professional.

Why?

• Theoretically speaking, it is impossible for anybody to understand your personal financial situation without seeing your personal financial situation.
• Panic selling is generally considered bad advice during market downturns.
• BUT, for someone with High interest debt, no emergency savings, and a job that’s potentially about to be replaced by AI…
• …selling off investments might actually be a sensible decision to cut out another risk factor.

The main point:

• Nobody knows exactly what’s going to happen next.
• The worst thing you can do is let people who get paid for clicks convince you to make decisions you wouldn’t otherwise make based on your specific situation.

More Content & Learning#

• An article is being written about the “almost comically bad use of AI in the financial sector”.

• This will be available on a free email newsletter.

• These kinds of money stories will never be made into videos on the main YouTube channel.

• If you’re interested, you can sign up at the link provided.

• If you want to explore another side of this market panic, there’s a video titled “who is going to keep businesses in business if they can replace us all with robots”.

• You can watch that video to keep learning about how money works.