Written by: Ryan Kelly, CFA® 
Chief Investment Officer, Legato Financial Group

Some days are just ugly. We have all had them—a day where nothing seems to go right, and we just feel a bit overwhelmed and incapable of winning. Today feels that way for stocks.

Like in any complicated story, market movements are an assortment of themes that wind themselves together and apart to create a larger narrative. The biggest theme in 2024 so far has been the massive rally of the Magnificent 7 stocks (NVDA, MSFT, META, GOOG, AAPL, TSLA, AMZN), also known as the AI/Tech Megacap trade. At their height about a month ago, the Magnificent 7 were up an average of about 40% YTD and were responsible for a huge percentage of the gains in the S&P 500 so far this year. This trade has been showing cracks for the past month, however, and appeared to fully break this morning.

Some of the first cracks developed after the failed assassination attempt on former President Trump, as his resultant boost in the polls saw some investors shift away from the Magnificent 7 and into sectors expected to benefit from another Trump presidency. That trade has faded as VP Harris’ poll numbers have improved dramatically over the past few days; however, several other developments have kept that momentum going.

There are also reports of a huge international carry trade being unwound. While this is a complicated subject for a quick market update, it all has to do with borrowing where interest rates are low and investing the proceeds in other markets where expected returns are high. In this case, traders have been borrowing money in Japanese Yen (at extremely low interest rates) and investing the proceeds in markets and securities that have been powering up (like US Megacap stocks.) Just a few weeks ago, the yen had fallen to a 38 year low against the US dollar on the back of this trade. The Japanese Central Bank then started intervening in the currency markets to shore up the yen’s value. They then raised interest rates on Wednesday of last week. Since these moves by the JCB, leveraged investors have been selling US Megacaps and buying back yen to close out their positions. Japanese yen vs. US dollar YTD below shows the big move throughout the year and the dramatic reversal in July and early August.

Earnings reports on the Mag7 stocks were mixed over the past week, which has done little to alleviate fears about their short-term strength. There are also several geopolitical risks in the market that could be weighing on performance (especially reports of an inevitable counterattack against Israel by Iran very soon), however, the market has largely shrugged off the other tragedies in the Middle East so far in 2024. Besides, if the market was worried about the Middle East, we would expect oil prices to spike up, and that simply isn’t happening. Oil prices over the past month have been dropping:

The next hit in the buildup to today’s sell-off came on Friday when weak jobs reports spooked investors into thinking perhaps the Fed has waited too long for their first interest rate cut of 2024. When the Fed started raising rates in March of ’22, it was expected that higher rates would slow the job market, however, they were willing to take that risk to reduce inflation. The Fed’s tools are a blunt instrument at best, however, and it can take months or even years for their actions to echo through the economy. If the Fed gets their timing wrong, the chances we will sink into a recession go up considerably. While investors are currently expecting a cut in September according to the CME’s Fedwatch Tool, it is easy for “Monday Morning Quarterbacks” to claim that Friday’s numbers are evidence the Fed should have started cutting already.

The brutal day in Japan on Sunday night/Monday morning is our most direct catalyst for the US stock market. The Japanese stock market dropped by over 12% last night, which was their worst day since 1987. Korea and Taiwan were down more than 8% and every single Asian market except for Mongolia was down overnight. European markets opened around 3am our time and were down about 2% on average. At 9:30 this morning, US stocks looked to be poised for a bloodbath. Every sector was down and some of the Mag7 stocks were down over 12%. The market then rallied back until about 12:30 and has since inched lower. What began as a more concentrated beating of megacap and tech stocks seems to have broadened to a more market-wide ugliness with fewer than 25 of the 500 or so stocks in the S&P positive on the day. Here is the S&P over the past 3 trading days:

NVDA and TSLA are now down over 20% from a month ago. Alphabet, Microsoft, Amazon and all down over 15% during that time frame. We will be watching these developments closely over the coming days and weeks. One positive to leave you on, however, is just how well the Mag7 have still performed YTD despite the recent selloff. NVDA is still up over 100% YTD. Below is the Bloomberg Magnificent 7 Total Return Index.

https://www.wsj.com/livecoverage/stock-market-today-dow-sp500-nasdaq-live-08-05-2024 https://www.cnbc.com/2024/08/05/carry-trades-a-major-unwinding-is-underway-amid-a-stock-sell-off.html https://www.cnbc.com/2024/07/31/japan-confirms-36point8-billion-yen-intervention-as-boj-hikes-rates.html https://www.mof.go.jp/english/policy/international_policy/reference/feio/monthly/20240731e.html https://assets.bbhub.io/professional/sites/10/Bloomberg-US-Large-Cap-ex-Magnificent-7-Index-Methodology.pdf