Market Turbulence Causes Collateral Damage

The global stock markets have experienced quite a tumultuous phase recently, and it is probably a subject that has captured the attention of even the most passive investors. Just as the world was recovering from Black Friday, which brought its own share of financial turbulence, the arrival of Black Monday took many by surprise. The market seemed to plunge into a frenzy, resembling a high dive into deep waters—unexpected and somewhat terrifying.

In the United States, the so-called “seven sisters” of the stock market lay completely silent, while European markets mirrored this decline with alarming results. The anticipation of rate cuts failed to stabilize the markets; rather, it felt as though they were on a downhill slope, spiraling rapidly. The situation was no less dramatic in Japan, where the stock market experienced a mind-boggling plunge that triggered a trading halt. Japan saw its Nikkei 225 index tumble by a staggering 12%, marking its most significant single-day drop since 1986. In just three days, the index lost 6,000 points—a drop that alone would outdo the combined losses of major Asian markets.

What exactly has unfolded? To understand the present chaos, it may be helpful to take a journey back in time—specifically to October 19, 1987, when the New York stock market endured its most substantial crash in history. On that fateful day, the Dow Jones Industrial Average plummeted by an astonishing 22.6%. Many investors found themselves financially ruined, having lost everything in a matter of hours. Coincidentally, it was a Monday, which led to this date being dubbed "Black Monday." In response to this catastrophic event and in a bid to mitigate similar risks, the U.S. Commodity Futures Trading Commission, along with the Securities and Exchange Commission, implemented a circuit breaker mechanism for the New York Stock Exchange and the Chicago Mercantile Exchange in 1988.

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The circuit breaker, a critical innovation in trading, serves as an automatic cooling-off period for stock exchanges. Simply put, when stock market fluctuations hit a predetermined threshold, trading is paused for a brief period—be it a few minutes or for the entire trading day. This strategy aims to calm investors, preventing excessive fear or euphoria, thereby curbing irrational trading and minimizing extreme market volatility. During the extraordinary global market downturn, Japan’s Nikkei 225 index encountered the circuit breaker multiple times, epitomizing how panic among investors prompted a massive sell-off that destabilized the market.

Many observers attribute Japan's stock market decline to the central bank's aggressive rate hikes. However, this assertion only scratches the surface of a more extensive set of interlinked causes. The anticipation of U.S. interest rate cuts scaffolds an undercurrent of concerns regarding a looming recession in the American economy. Investors globally appear to have collectively concluded that a downturn is inevitable. When compounded by rising capital costs prompted by the Bank of Japan’s rate increases, the market unveiled cracks that simply could not withstand further pressure.

For decades, the yen has found itself utilized internationally as a tool for arbitrage, primarily due to its comparatively low cost. However, the Bank of Japan's recent move to increase interest rates to 0.25% marked a seismic shift. While the number itself might seem minimal, it effectively inflated corporate financing costs by 2.5 times. For a currency that has long been the go-to for arbitrage, this increase adds stress to a system that was already teetering on the brink.

This chain of events ignited a global shockwave. The correlation of these rate hikes with mounting U.S. recession fears paints a grim outlook for the market. But why is there an escalating buzz surrounding U.S. interest rate cuts and recession predictions? The explanation lies in increasingly concerning economic data emanating from the U.S. In July, the ISM manufacturing index fell significantly short of expectations, recording its most considerable contraction in eight months. Moreover, the non-farm payroll figures, reflecting only an addition of 114,000 jobs, also missed the anticipated mark of 175,000, not to mention a rise in unemployment from 4.1% to 4.3%.

This uptick in the unemployment rate is noteworthy; it aligns with the “Sam Law,” a historical metric that has proven to forecast U.S. recessions with 100% success. This law states that a moving average of the unemployment rate over three months surpassing the lowest level from the previous twelve months by more than 0.5 percentage points signals impending recession. Now, with the unemployment rate rising to 4.3%, the margin crossed 0.8 percentage points, indicating that the American economy is teetering dangerously close to recessional territory.

Moreover, one cannot ignore the backdrop of the staggering U.S. debt situation. Currently, the U.S. national debt sits at a staggering $35 trillion—an alarming number that starkly contrasts the $4.1 trillion accumulated by 41 preceding presidents over 217 years before Clinton’s term. As the debt continues to mount, the options for addressing this burgeoning crisis become limited: spur economic growth to generate revenue, roll over debt to accrue further obligations, or hope for external circumstances to alleviate the burden.

Encouraging growth amidst these pressures presents a significant challenge. This past year, Italy’s GDP grew by only 0.9%, France by 1.1%, and Japan actually saw a 0.7% contraction in the first quarter. Despite the U.S. employing aggressive monetary easing, it achieved a mere 2.5% growth last year. Predictably, analysts foresee that, regardless of who occupies the presidency, U.S. debt will continue spiraling, necessitating immediate rate cuts to stave off the risk of failure to meet interest payments.

However, following the storm on Monday, a remarkable change took place on Tuesday, ushering in a bright, optimistic atmosphere. The Nikkei 225 index skyrocketed, contributing to a recovery in Asia-Pacific markets, with the Korea Composite Index among those experiencing impressive gains. Futures for the Nasdaq 100 index, S&P 500, and Eurozone’s STOXX50 also showed marked rebounds. This volatility puts investor confidence to the ultimate test, requiring a strong heart from those wishing to engage in this rollercoaster of investment opportunities.

This turbulence underscores the importance of robust investment strategies rooted in industry fundamentals. The period leading up to a storm is often when retail investors become the most vulnerable, particularly amidst uncertainty. For instance, consider the Futu case on August 5, when customers were informed at 10:30 PM about canceled orders, resulting in significant financial losses. In this scenario, while buy orders remained intact for the SQQQ, sell orders were inevitably canceled. This led to a volatile rebound in the Nasdaq, generating losses for SQQQ holders caught off-guard. Some individuals faced even graver situations, with low-price buy orders canceled, high-price sell orders invalidated, and platforms transforming transactions into precarious short positions. Such alterations to client account transactions could result in catastrophic financial detriment, even pushing some accounts to the brink of forced liquidation.

For retail investors, the feeling of helplessness can be overwhelming at times.