Harry Geels: Three 'butterfly effects' of securities markets

August 6, 2024

_{This column was originally written in Dutch. This is an English translation.}

By Harry Geels

Securities markets have various flywheels that amplify price movements up and down. When they start turning, we regularly get bizarre movements, such as the last trading days, now mainly thanks to the 'carry trades' in Japanese yen.

It is difficult to properly explain price movements. But humans always have an insatiable need for explanations, preferably in the simplest possible terms. Stock market analysts and journalists earn their living from it. For example, the financial community explained the recent 'unexpected' large decline in the stock markets largely on the basis of disappointing American macro data, in this case on unemployment (more unemployment claims than expected) and the ISM index, which was two percentage points lower.

But it's not that simple. Of course, prices fall when figures are disappointing, but if the decline, that is to say in shares, is suddenly large and volatility increases considerably (a VIX of now around 50 indicates a real crisis), the matter is, as always, more complicated than it is presented. Financial markets are complex and this is due to factors such as mass psychology, geopolitical issues, intermarket flows and the influence of central banks. Without pretending to provide a sufficient explanation, three 'butterfly effects' now play intriguing roles.

Carry trades

Last week, carry trades were reversed on a large scale. It is mainly the Japanese yen that is used by speculative investors to borrow cheaply in yen and then invest in other currencies (with higher yields) (especially in bonds). An important news event last week was the increase in the Japanese policy rate by 0.25 basis points. A historic step that may indicate the end of Japan's monetary policy of cheap money and the importance that the Bank of Japan attaches to a stronger currency. The unwinding of carry trades amplified the decline in equities and also led to huge moves in currency markets, such as the AUD/JPY, with the Australian dollar falling more than 15%.

Monetary policy, more specifically quantitative easing

A second important effect is monetary policy. That is a subject in itself, because this takes place at different levels, such as through interest rates, quantitative easing and support of the financial markets by central banks in times of crisis. For now, suffice it to say that the Fed's balance sheet is correlated with the securities markets: the larger the balance sheet, the more liquidity flows into the markets. In recent months, the problem had arisen that equities rose while monetary tightening took place. This discrepancy has been corrected due to the recent stock market decline.

Margin debt

Finally, the phenomenon of margin debt, the buying of securities with borrowed money. Currently, about 20% of the S&P500 has been bought on the spot. Margin is also a complicated phenomenon, but in general there is a stable correlation between margin debt and prices. A cautious conclusion is that margin debt strengthens the movement, especially during declines, because investors who have bought with borrowed money then have to close purchased positions. This also seems to have happened last week ('when forced margin selling took place'). A complication here is that interest rates are considerably higher than two years ago and therefore margin is expensive.

Two closing remarks

Butterfly effects (and black swans) make stock markets difficult to predict. This became clear once again in recent days at the fair. For now, it is just as easy to come up with a 'narrative fallacy' for a further decline in prices as it is to argue that we are close to a bottom. It is important to state that share prices rise in the long term, bull markets more often show these types of corrections and therefore often offer interesting entry points, a VIX of 50 statistically often reflects such an entry point, and that diversification is important to make sure that too large a decline can be made up for.

The second comment concerns risk management. It is an almost impossible job because of the butterfly effects. Or as the unsurpassed Nassim Taleb puts it: 'the job of risk manager feels strange' because seeking out risks can also make money for shareholders. The best form of risk management is probably knowing exactly which companies you are investing in and whether they can easily survive a crisis, or better yet, benefit from it. If you have enough of that in your portfolio, you will be fine in the long run.

PS: When John Pierpont Morgan was once asked 'what do you think of the markets?', he replied: 'They will fluctuate'.

This article contains a personal opinion from Harry Geels

More columns by Harry Geels