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💰 When the market tanks...
Preston Victory
August 14, 2024
Welcome, Future Early Retirees.
Last week (8/5/2024 - 8/9/2024), the stock market had its worst performing day of the year, as it dropped 3.3% 😱. This caused a brief moment of panic with people fearing it would drop further. However, those fears were short lived as the market has been recovery steadily since. What exactly caused this to happen and how can you learn from it as a future early retiree?
In today’s newsletter:
What happened?
Have you noticed interest rates are a lot higher than they were a few years ago? That is because the United States federal reserve elected to raise them in order to lower inflation to its targeted 2%.
Other countries have a similar setup where they have a central bank whose job is to manage the amount of money circulating in the economy. If there is too much, inflation gets out of control like it did in 2022 when the peak inflation number was over 9%. They also have to consider whether they are allowing healthy growth. Higher interest rates force people to borrow less, which means less money is being created and entered into the economy.
Why am I telling you this? Japan’s central bank has had negative interest rates since 2016, meaning you pay back less money than you borrowed. This created a unique situation where you could take out a loan in Japan in yen, convert it into US and then put the funds into certificate deposits (CDs) that were earning over 5% in interest. This was a “risk free” (not really) approach that allowed you take out money and earn some extra cash for your investments. That is, until the Central Bank decided to raise interest rates 35 basis points (0.35 %) due to their own high inflation on 7/31/2024.
The Yen appreciated a lot against the US dollar in terms of the exchange rate and all of a sudden people were not in a position to pay back their loan! Not good.
Many institutional investors and businesses who had adopted this strategy had to sell some of their investments in the stock market in order to pay off their loans. This is what caused the stock market to drop drastically.
How did the market recover so quickly?
The reaction to the interest rate hike was so strong, the Japan Deputy Governor announced they would hold off on raising rates until the financial markets were more stable. People breathed a sigh of relief as this prevented further sell offs and people started buying again as they became confident in there being no crisis.
Key Takeaways:
The U.S. Federal Reserve raised interest rates to combat inflation, which peaked at over 9% in 2021, while other countries also manage their economies through central bank policies.
Japan maintained negative interest rates since 2016, allowing investors to borrow cheaply and invest in higher-yielding assets abroad, but a recent rate hike led to a stronger yen, complicating loan repayments.
The initial market downturn due to forced asset sales by investors was mitigated when Japan's Deputy Governor announced a pause on further rate increases, restoring investor confidence and stabilizing the markets.
How can we learn from it?
Have high conviction. No matter how much you want be in control of your investments, there is always something that is outside your control. That is why it is so important to have conviction and ensure your portfolio is setup to where the risk match ups with your goals and tolerance of market downturns. We would all love it if the market went up nice and steady, but we will don’t live in a perfect world.
The market will test your conviction in an investment constantly with many days it decreasing in value. Understand why you invested in a company, fund or whatever the opportunity is. It’ll help you have a long-term focus.
For example, one of my investments is an S&P 500 index fund. This is essentially a representation of the US economy. I have all the confidence in the world it will continue to go up over the next 30-40 years even if we have a downturn sometimes. That is because I believe the US economy will continue to grow and prosper over the long haul.
"In the short run, the market is a voting machine but in the long run, it is a weighing machine" – Benjamin Graham
Understand how the market works. Nothing about the large drop in the market had anything to do with the companies themselves. They didn’t all of a sudden lose value. Stock prices are fundamentally determined by the interplay of supply and demand in the market. When more investors want to buy a stock (increased demand) than sell it (decreased supply), the price moves up. Conversely, if more investors want to sell a stock than buy it, the price falls.
Short-term Fluctuations. In the short term, stock prices can be influenced by various factors that may not directly relate to a company's fundamental value:
Market sentiment: Investor emotions, such as fear or greed, can drive rapid buying or selling.
Speculation: Traders may buy or sell based on predictions about future price movements rather than company fundamentals.
Technical factors: Chart patterns or trading algorithms can influence short-term price movements.
Long-term Value. Over the long term, you're correct that a company's stock price tends to align more closely with its fundamental value. Factors that drive long-term stock performance include:
Earnings growth: Consistently increasing profits typically lead to higher stock prices.
Competitive advantage: Companies with strong market positions often see sustained stock price appreciation.
Industry trends: Favorable industry conditions can boost stock prices across an entire sector. Lower interest rates, for example, are good for car companies since people can afford to finance more expensive cars.
While the market can be irrational in the short term, it tends to be more efficient over longer periods. This means that stock prices eventually reflect all available information about a company's prospects and value.
However, it's important to note that even long-term stock performance can be influenced by factors beyond a company's control, such as changes in the broader economy, shifts in consumer behavior, or regulatory changes.
Key Takeaways:
Maintain strong conviction in your investments and align your portfolio with your risk tolerance and financial goals to navigate market downturns effectively.
Recognize that short-term price fluctuations are often driven by market sentiment and speculation, while long-term stock performance is influenced by fundamental factors like earnings growth and competitive advantage.
Embrace a long-term perspective, as the market tends to reflect a company's true value over time, despite short-term irrationalities and external factors beyond your control.
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