Stock Market Crashes while Crypto and Risk Assets Nuke as Fears of a Recession Mount

Judging solely by the VIX, the market’s “shit hitting the fan” indicator, we entered a historic crisis today. It had its largest intraday move ever, and it wicked up to its third highest figure of all time, only behind the Covid plunge and the Great Financial Crisis of 2008. The S&P 500 gapped down four percent to open the day, a huge move, and the Nasdaq gapped down over five percent. Markets began the session in sheer panic on the back of Japan’s Nikkei having its worst day since 1987, a year that is synonymous with market crises.

Friday’s incredibly weak U.S. jobs report suggests the economy is slowing down, and it activated the Sahm Rule, which has a near-perfect hit rate at predicting recessions. Elizabeth Warren called on the Fed to cut interest rates immediately, as she asserted that their goal to slow the economy down has been achieved and it’s time to take the chains off of it, and markets across the world backed her up today.

According to the VIX, the worst market events of our lives were the 2008 financial crisis, COVID, and the Bank of Japan raising interest rates by a quarter percentage point. pic.twitter.com/yyS7VwYyGT

— Douglas A. Boneparth (@dougboneparth) August 5, 2024

This tweet cuts to both the humor and the heart of the problem here. First, how in the world is a 25-bps rate hike by the Bank of Japan the end of the world???

But also, it kind of is! Look at that move! Something is happening, and I would bet that the largest spike in VIX history is mainly reflecting the unwinding of “the biggest carry trade the world has ever seen,” according to a SocGen strategist (more on that in a bit when we travel to Japan).

I asked a friend who works in finance about this wild VIX move, and he said “One day spike = not noteworthy. Prolonged wave = buckle up.” While I don’t want to make the same mistake many market participants got punished for today and get out over my skis predicting the future, with how swift and violent these moves are, it actually may indicate that this is more about market dynamics than a broader impending crisis as suggested by the VIX.

Outside of macro concerns about the economy that have been raised in recent months, there are two clear roots to today’s wipeout, and let’s start with the obvious one that Warren Buffet helped illuminate last week when he cut his Apple stake in half in a bid to be more “defensive.”

Risk Assets Like A.I. and Crypto Are Tanking

In nearly every article I have written about the stock market in new Splinter‘s short history, I have referenced the Shiller PE or CAPE Ratio, the favored metric of my favorite professor in my Finance Master’s program, pegging this market as the third-most expensive stock market relative to earnings in over a hundred and forty years. We are clearly in some kind of A.I.-driven bubble, and at least in the context of the last few weeks (which admittedly isn’t a ton of data to a fundamental analyst), it looks like it’s bursting. Nvidia, the poster child for the AI boom, closed today down 28 percent from its all-time high made at the end of June.

NVIDIA and Taiwan Semiconductor Manufacturing are facing production challenges with the next generation of its AI chips – FT.

— Markets & Mayhem (@Mayhem4Markets) August 5, 2024

The problem is that A.I. demands massive amounts of investment that its revenue cannot justify, which the market is beginning to wake up to. As Ed Zitron noted:

In the last fiscal year, Microsoft’s capex (capital expenditure) was $55.7 billion, up 75% year-over-year, with more than one third ($19 billion) spent in the quarter ending June 30 2024. This is reportedly split 50-50 between infrastructure and tech, which suggests an aggressive data center build-out, with Chief Financial Officer Amy Hood saying that Microsoft “expect[s] capital expenditures to increase on a sequential basis” given cloud and “AI demand” that, as I’ve just said, isn’t really there.

Speaking of demand that isn’t really there, crypto is getting annihilated. Just looking at Ethereum’s chart makes my eyes bleed. It’s had seven straight negative days, wiping out as much as a whopping 37 percent of its value at its low from last night when it teleported from $3,000 to just over $2,000 in what seemed like seconds. Bitcoin has fallen from nearly $70,000 to $54,000 in the last two weeks.

Risk assets, like A.I. and crypto, are fun in low-interest rate regimes when the economy is good and money is cheap and you can afford to gamble, but when money gets expensive and the economy goes down, owning things that actually make stuff that people use is a much better option for investors like Warren Buffet.

Every doofus who called for a new bull market in a 2000s-style A.I.-driven boom and put their money where their mouth is got crushed today, and going forward, there will be much more scrutiny on these companies’ profitability, which so far is not great as Ed Zitron has detailed time and time again. Bitcoin and Ethereum have ETFs now and are part of the system they aimed to destroy, so crypto is likelier to move with the broader market than they were before, instead of being moved by the emotions of a bunch of 20-something crypto traders and the crypto hedge funds riding their waves.

For the last month, the market has been pointed down, accelerating hard today as gargantuan companies like Apple closed down just under five percent. It’s possible that today is the bottom for risk assets, as this has all the hallmarks of a capitulatory event, but we are entering a new world for the big players in the market, driven by Japanese monetary policy. The market could recover but risk assets may not.

Japan’s Role in this Mess

“The Japan carry trade” is a simple strategy that hedge funds have followed for over a decade, as the Bank of Japan’s (BOJ) loose monetary policy has allowed many of the market’s big players to borrow in Japanese Yen for next to nothing, and then they would buy U.S. stocks with the money they borrowed. Because the stock market is up only in the long-term, this was essentially free money for years for big funds. Everyone smashing the sell button at the same time today and last night at the Nikkei open is as good of a sign as it gets that this belief in free money is no more.

Twenty-five basis points may seem small, but in the world of interest rates, these moves can be large, and leverage has the dynamic of exponentially exacerbating any issues. That said, the spread between U.S. and Japanese interest rates is still sizable, and there’s no obvious reason all these big players couldn’t jump back in with a tweaked strategy tomorrow.

The reason that normal people should be concerned about this is that the stock market has created a very large wealth effect that has helped buoy the post-Covid economy. One study suggests that for every dollar of stock market wealth, 32 cents worth of consumer spending is created, and the American economy is about 70 percent consumer spending. Interest rates make the world go ’round because they are the price of money, and when they go haywire, the world goes haywire, as we are seeing now.

Japan has been a beacon in a loose monetary world, and them capitulating and joining the rest of the planet in raising rates is the door slamming shut an on era of free money. “This is not the recession train; it’s just a good old-fashioned market panic,” Joe Brusuelas, principal and chief economist for RSM U.S. said to The Washington Post. “This is not a D.C.- inspired event, about a slowing job market or the Fed being behind the curve. It’s about a larger regime change, where investors are adjusting to the end of easy money globally.”

How Worried Should We Be About the Economy?

This is the $64,000 question at the heart of this game around the U.S. economy since the pandemic, as we have experienced levels of inflation not seen in decades, while at the same time growing faster than any other western nation post-Covid.

The stock market is not the economy because it is forward-looking by its nature, but we have seen time and time again how it can either portend or help deliver doom to the broader economy. Bank stocks fell hard today which is not a great sign, as they are the closest representation you will find in the stock market to the real economy, and the fear from my limited MS vantage point is both how far the market can still reasonably fall after today’s bloodbath and what that could do to banks currently sitting on billions of unrealized losses.

Elizabeth Warren is raising alarm bells about the economy too, as she is citing data like the Sahm Rule which are “flashing red.” Today her nemeses on Wall Street joined her in this panic about where we may be headed, as the notion that the Federal Reserve made a policy error both in not raising rates soon enough and leaving them too high for too long is taking root. It’s anyone’s guess what happens next, but it’s clear that the market realizes an era of free money is over while the economy is slowing down. That dynamic is not a good one, and should the stock market follow through on this panic in the coming weeks, it will surely hit the real economy at some point, and then we will really know how good or bad it actually is.