In case you hadn’t noticed, there was a bit of market volatility last week. If you watched CNBC or another market outlet, it seemed like the end of the world, and then there was a miraculous comeback, and if you ignored it all, you might see a small pullback in your balances but nothing alarming for a seasoned investor.
Background
Last week I posted The Sky is Falling, Please Don’t Panic and This Isn’t Helpful. I posted both in an attempt to calm fears. The stock market can be crazy at times. It happens regularly, but in the long run, it has always gone on to new highs after every pullback.
The Japan Carry Trade
There is rarely 1 factor that causes the market’s movements, but the Japan carry trade was one factor in last week’s excitement.
Raise your hand if you’ve noticed interest rates rising? Here in the US, a 1 year treasury that received 0.5% interest in 2021 was receiving 5% interest in 2023. That’s huge. Our US Federal Reserve raised interest rates to decrease the money supply in the hope that less money in the system would bring inflation down. This tends to work but it is very slow (think years) and is imprecise.
Not all countries followed suit. I read a while back about how Turkey had decreased rates to help the country deal with inflation. Not sure it worked out that well for them, but love their creativity.
Japan kept its rates fairly flat. While it was costing north of 5% in the US to borrow money, taking a loan in Japan in Japanese Yen was much cheaper – often less than 1%.
Some clever international investors said “Hey wait a minute…If I borrow in Japan (I don’t need to hop a plane, I can do this online) and invest that money in the US – maybe a nice low-cost S&P 500 fund, I could make a killing.”
That’s a simple version of the Japanese carry trade. To read more, click here to see what our friends at the Motley Fool have to say.
Leverage
Be careful of using leverage. Leverage is borrowing money to fund an investment. More here from investopedia.
Leverage can significantly increase gains when done well, but can wipe you out if something unexpected happens.
Something Unexpected
In investing, something unexpected always seems to happen. While we have evidence that in the long-term, the broad US equity market tends to increase, we have no idea what will happen in the short term.
And in this particular case, add in another country – Japan, and currency fluctuations, it’s tough to be right.
I stay away from using leverage.
Why Do We Care?
While we don’t want to watch the market minute by minute and react to the latest headline, it is important for us to understand significant events that do have an impact, if only in the short term.
The Japan carry trade was a great idea. So was betting on housing in the US in 2005, 2006, and 2007. Most bad ideas started as good ideas.
The unfortunate part for us is that even if we are a conservative investor, buying low-cost S&P 500 index funds and bond funds, we are impacted by the broader market. While S&P 500 companies like Coca Cola, Walmart, and Amazon didn’t all of a sudden become less important and less valuable, they did become less valuable in the eyes of the “market”.
Emotion
The stock market trades on emotion. There are stacks of research reports, earnings reports and other materials available. Equity investing can seem like a science, but it’s not. How do we explain why a small fintech company called Upstart Holdings was up 44% last week. Read here. A lot of the trading is done based on emotions.
This gets amplified when you factor in that a large part of market trading is done by computers. As volatility hits, the computers start trying to make sense of new and unexpected data and they start trading and that amplifies whatever is going on.
Wrap-Up
So today we learned what a carry trade is (borrowing to invest – yuck) and we understand how the Japan carry trade impacted the markets last week.
Hopefully the lesson we take from this is that markets can be irrational. One of my favorite quotes is “Markets can be irrational longer than you and I can remain solvent.” This reminds me not to bet on the market’s short term movements, especially using leverage.
It also reminds me that while the market will have long periods of irrationality, it always seems to come back to some level of normalcy. The S&P 500 has gained about 10% with dividends reinvested over the last hundred or so years. While we could lose money in the short term (less than 5 years), our odds are good that in periods longer than 5 years, we’ll do quite well. And as our timeframe gets longer, the odds of us growing more wealth are higher. Read more here.
So we keep money we need in the next 5 years in low-risk asset classes like cash, and maybe some low-risk fixed income. We don’t try and make a big score. We put our long-term assets in the US markets, or maybe some in emerging markets or other more risky plays, and we’re patient.
There will be more events like the Japan carry trade and they’ll likely have a (hopefully brief) impact on us and our investments. Allocate your capital effectively – read more here, and keep focused on long-term goals.
Thanks for reading.