Risk of Recession

Current State of the Market

Until late July, 2024, market indices had accelerated upwards throughout the year at near record speeds. From January through mid-July, the S&P 500 gained 19.5%. Continued growth at such a pace would place this year among the top three of the last thirty years, for the index. Much of the recent growth has been thanks to the Magnificent Seven, all heavy-hitting tech stocks that, in total, accounted for 37% of the index as of six weeks ago. Ten years ago, they made up only 14% (CNBC Mag 7). Numerous investors have labeled the boom in tech stocks an unsustainable bubble, sure to eventually burst. Over the past week (Jul 29-Aug 5), apparent asset rotation out of tech stocks may appear to prove these naysayers right. These large-cap tech stocks have now led a substantial market correction—perhaps, now, they may be considered the Maleficent Seven. As of today, August 6, a tech rebound is underway. It remains to be seen if this is but a temporary upward bounce amid a market downturn, or if the correction itself was the temporary occurrence.

Some have described this tech stock selloff as irrefutable proof that the market was indeed in a bubble, and that a recession is therefore waiting in the wings. While this may or may not turn out to be the case, there are more consequential factors to consider in this scenario. Particularly, a lackluster jobs report, events in Japan, the looming possibility of war in the Middle East, and the evolution of investing styles over time all play roles in this current market reality.  

A recent jobs report displayed that 114,000 non-farm payroll jobs were added to the economy in July, compared to the expectation of 175,000. Clearly, this is a substantial miss, and along with it, the unemployment rate rose to 4.3%, which is the highest since October 2021. This report appears to be a much more reasonable catalyst for a temporary shift in investor sentiment. I say “temporary,” because it has been widely expected that a federal rate cut of up to 50 basis points will occur in September, even more so now, in light of recent data. Any such cut is likely to reinforce widespread bullish sentiment and resurrect this year’s rally.

Ismail Haniyeh was assassinated on July 31 in Iran. He was a well-known Hamas leader  portrayed by the media as a peaceable, nonviolent diplomat in the wake of his death. It is indeed such a shock that the average individual trusts the media less with each passing day. Anyways, fears mounted upon the possibility of escalation in the region, particularly considering Iran’s boisterous threats. Yet, it quickly became clear that market makers weren’t particularly worried about that. A tool often used to gauge the public perception on threats in the Middle East is the Brent oil price. When a serious threat is perceived, oil prices rise, quickly. Since the 31^st, the price fell, before slowing clawing back some losses, continuing a short-term trend. Accordingly, we deduce that any current regional threat is likely considered insubstantial, due to the lack of notable movement.

Also on July 31, the Bank of Japan decided to raise its key interest rate to 0.25%. Many investors, over quite some time, had participated in a yen carry trade, where they would borrow yen or short-sell Japanese debt instruments, at Japan’s extremely low rate, reinvesting the proceeds in other countries where they could profit from arbitrage. One factor leading up to the Bank of Japan’s decision is their nation’s deep reliance on US imports. Federal rate increases had strengthened the dollar against the yen, resulting in substantially higher costs for Japan. The BOJ’s subsequent raising of their rate has already, and may continue to, strengthen the Yen and thereby lower Japanese costs. Additionally, it may serve to retain additional investment within Japan—a massive quantity of investors to date have borrowed in Japan and invested proceeds anywhere but Japan. Regardless of Japan’s rationale, though, the impact on US markets remains the same. Many investors who utilized a carry trade to invest in US securities now face margin calls due to the higher interest rates on debt. Resultingly, they are selling their assets to cover, driving the US market lower.

To some, it may appear that the perfect storm is taking place amidst US equities. On Wednesday July 31, significant events took place in both the Middle East and Japan’s financial system. Major US companies shed immense levels of value over the following days, with the poor jobs report extending the downtrend through Monday August 5. However, the accelerated value elimination of the moment is due in large part to an entirely non-fundamental factor. Whether or not the US economy is bound to crash and burn at some point in the future, due to our immense debt and seemingly exponential public spending, is an entirely separate question from what I attempt to address here. Here, I  make a case as to why the current market correction is far overblown and how its most proximate causes have gone largely unmentioned.

Market Democratization and its Implications

While the aforementioned events are certainly affecting the market, much of the downward action is due to a general panic of average investors, who are wholly unaffected by the BOJ decision. The CBOE Volatility Index, VIX for short, is a widely recognized “fear index” for the US market. When investors anticipate a major drop, this index spikes. From July 31 to August 5, it climbed 236%. For reference, at the onset of Covid, it powered upwards by 383%. Regardless of the true long-term dangers of Covid, the disease initially caused one of the fastest drops in stock market history. The fact that, in the last week, a few largely inconsequential catalysts have caused a comparable degree of fear within the market simply reveals how emotional the US stock market has become. This shift towards volatility and irrationality is a direct result of large-scale market democratization—this term refers to the increasing prevalence of individuals gaining access in the market. Understanding this concept, its causes and its outcomes, is crucial. If one learns to recognize the difference between market cycles that are largely irrational and those which are fundamentally sensible, one may find new opportunities for arbitrage. Then again, it is obligatory to quote Keynes as we discuss market irrationality: “The market can remain irrational longer than you can remain solvent.” This is important to bear in mind whenever an attempt is made to capitalize on perceived irrationalities.

In the last decade or two, the market has become increasingly emotional and irrational as individual investors accrue progressively greater influence over the end destination of their funds. The rise of technology has largely facilitated this shift. Trading apps, online advisors, social media, and the ability to purchase fractional shares have all encouraged the average individual to become involved in investing. In the decade spanning 2009-2019, the share of US individuals under 40 years old who invest more than tripled (JPMorgan). Later, during Covid, there was naturally a large spike. Many had disposable income thanks to stimulus checks or the pairing of remote work and less expenses. I should of course note that the share of investors aged 40 or higher also increased during that period. However, it grew by a mere 60%, compared to 200% or more for the younger group. This difference in growth rates has caused a gradual increase in younger generations’ market representation. From nearly equal shares of individuals investing within each age group in 2015, the investing share of the younger group is now 1.7x that of the older. Finally, in the 27 years leading up to 2022, the share of under-25-year-olds who invest grew from 16% to 40% (Bloomberg).

All the preceding data is intended to showcase the steady shift of market capital into less experienced hands, especially younger ones. Having said that, being young is not a necessity—these financial and technological developments grant risk-takers of any age simpler means of investing where they please. A Goldman Sachs survey in late 2023 revealed that 47% of Americans self-manage their retirement portfolio; yet only 13% correctly answered five basic questions on financial literacy (Goldman). This shows that nearly three-quarters of self-managed portfolios are directed by individuals lacking in financial aptitude. This certainly increases the degree of emotional trading in the US market.

Before taking this discussion any further, the presence of institutional market dominance should be addressed. Institutions own 60-70% of all US stocks and are responsible for roughly 90% of daily trading volume. These facts may appear, at face value, to diminish the impact of market democratization on volatility and direction. However, one must consider that ETFs, 401(k)s, mutual funds, and insurance policies typically fall under the umbrella of “institutional” investors. An individual, by selecting an ETF or mutual fund based on the holdings within, or by self-directing their retirement and insurance accounts, may maintain majority if not full control over which assets they invest in. They will often have to select a basket of securities, which may weaken their control over the particulars—but they can find whichever basket includes the stocks they prefer and invest in it. Thus, a significant portion of institutional investment is still essentially controlled by individuals. On many life insurance policies and retirement accounts, there is an option to withdraw funds from the market and place them instead in an interest-bearing account. Due to the presence of that option, individuals are free to emotionally withdraw “institutional” funds from the market in a panic sale. On the other hand, individuals are free to concentrate their portfolios, to varying extents, in whichever sector they may be optimistic about. Often, there are some limits in place, but not enough to materially prevent emotional trading.

Market democratization is clearly evidenced by the increasing degrees of investment within younger generations, self-management of retirement assets, and additional provisions for individual influence in institutional accounts. Increased access to trading, ease of investing, and availability of information have led many to feel confident enough to manage a portfolio themselves, irrespective of whether that confidence is grounded in reality. It is certainly possible to teach oneself how to optimally invest, given the sheer quantity of information available online. However, it is equally possible, indeed more likely, that someone will attempt to learn riskier investing styles that are prevalent on social media. This is largely resultant of the jealousy endemic to recent generations that have been raised online. Many will witness countless “successful” lifestyles portrayed online and desire the same for themselves. The pursuit of this success leads many young people to chase get-rich-quick schemes, where the vast majority lose much of what they initially owned. These schemes are a large driver of the irrational, emotional trading strategies that are seen at an ever-increasing frequency. In the end, no matter how confident individual investors are, reality shows that most of them have much more to learn. But, if the base level of inexperienced or uneducated short-term investors continues to grow, market volatility and irrationality can only be expected to increase. All that now discussed, my position, once more, is that the drastic market movements across the past week can be largely attributed to these changing demographics and motivations within the market.

The Real Threats: Inflation & Unfettered Spending

One of the most important reasons to truly worry about the long-term performance of equities has been hardly acknowledged as of late. Our government has been recklessly spending and less than transparent about the impact of such behavior. The White House Council of Economic Advisers on June 12 issued a report on headline CPI growth versus wage growth. To say the least, it appeared to be intentionally misleading, which does not surprise me. The current administration has tended to create problems by acting irresponsibly, then twisting facts for as long as they can to deny the problem, and finally, blaming someone else for it once outright denial becomes impossible.  

Doling out billions of dollars far beyond what is necessary is understandably not a reliable strategy for keeping inflation under control. The White House would have you think otherwise. They do have to buy their votes somehow, after all. A recent report displays wage growth as of late versus headline CPI, which includes goods with volatile pricing such as food and energy. Another often-used measure is core CPI, which tends to paint a more realistic picture, by leaving out those categories that are tumultuously priced no matter the underlying factors. The White House CEA report in question touts the administration’s success in bringing inflation under control (White House). To verify this accomplishment, they display a graph that shows the wage growth rate creeping above the headline CPI rate for the first time in over a year.

This is dubious reporting, put simply. As I read the report, I remembered various times that the Biden administration used the core CPI as a talking point. These memories caused me to wonder, naturally, what might determine which CPI measure the White House reports on at a given moment. My first thought was that they simply report on whichever measure makes them look best. Logically, one of the two CPI measures will always paint a brighter picture for the economy than the other. It did not take much digging to support this idea: another White House CEA report from as recently as July 11 lauds the administration for the reduction in core CPI. I scoured the article but did not see a single mention of headline CPI. This was one month after the report that spoke solely on the headline measure.

The June 12 article pats the Biden administration on the back: “The gap between [headline CPI growth and wage growth] shows that yearly wage growth has exceeded price growth for 15 months in a row.” (White House). This statement relies on incorporation of food prices into the CPI measure, which a statistic involving the core measure would not allow for. Food price growth has slowed dramatically since August 2022, from highs in that month of 11.4% year-over year, to a low of 2.1% in May 2024 (Trading Economics Food). Hence, the CEA makes absolutely certain to take full advantage of food price reduction by using a measure that includes it. Allow me to reiterate that the two goods excluded in core CPI are food and energy, as their prices tend to be volatile. I have shown why this administration would want to include food prices in their CPI measure—but what about energy prices? Unsurprisingly, energy prices dramatically decreased over the same period, from an initial yearly growth rate of 23.8% in August 2022 down to 3.7% in May 2024 (Trading Economics Energy).

Without inclusion of the decline in price growth among these two factors, food and energy, it is doubtful that the White House could claim anywhere near 15 months of wages outpacing inflation. A simple means of checking whether the above-mentioned price shifts could be reason for the focus on headline CPI is to check the historical rates of headline and core. A quick search reveals that in August 2022, headline CPI dipped below core, after being above it for over two years, and it has remained lower since then (EconBrowser). Clearly, this is thanks to the rapid decline of food and energy prices, as those two things are the sole differences between headline and core CPI. As the full 15 months lauded in the report took place after this reversal, the CEA claims that wages have outpaced inflation over that period is reliant on the use of headline CPI. Simply put, headline CPI has set a lower bar to clear since August 2022. Beyond even this, if we trace their claim back 15 months from their press release, we get to March 2023. According to the same chart referenced above, the core CPI growth rate is to this day higher than the rate of headline in March 2023. Not much critical thought is required to deduce that, had they contrasted wage growth against core CPI, their celebrated 15 months would likely turn to a few months at maximum.

This blatantly skewed reporting by no means guarantees a future recession, but it certainly is a warning sign. Through the preceding section, my primary intent has been to highlight the intentional mischaracterization of reality by the current administration. Of course, every administration is guilty, to various extents, of this. But, through the actions of this administration, inflation has gotten out of control. When a more accurate measure of inflation is used, real wage growth is either lagging behind or just barely keeping up. Even if we were to take White House reports as gospel, without questioning them at all, it would remain true that two full years of Biden’s presidency resulted in a continual decline of real wages. Patting Biden (more realistically, his handlers) on the back for finally getting things “right,” months before the end of his presidency, is laughable. Again, even that hypothetical scenario assumes that the White House has been honest. The fact that, in reality, they have congratulated themselves while misleading the public, in order to convey a false narrative of Democrat success, is indeed deplorable.

Conclusion

No matter what, we should certainly expect a sustained increase in average volatility moving forward. Said volatility can make it difficult to keep a cool head in the market, as major indexes gap down 4-5% multiple days in a row, following relatively unimpactful news. Regardless, one must learn not to panic in those situations. The rising tide of individual investors within the market has led to a higher extent of emotional, irrational trading. When any negative news comes out, regardless of its true scope, panic sales should be expected. A more volatile market will result in more extreme price movements in response to just about any event. Seasoned investors may compare today’s turbulent market to that of decades ago and believe that a major crash is the inevitable result of such extreme daily losses. Sure, a major crash may occur eventually, given all the pieces in play—but events such as a lackluster jobs report or a slight hike on the Yen’s interest rate do not necessitate the immediate destruction of US equities. They may be factors in the lead-up to a recession, but the fact remains that today’s market emotionally overreacts to all news, good or bad. As always, the long-term winning strategy continues to involve investing in robust companies or sectors, diversifying your holdings, dollar-cost averaging over time, and doing your best not to panic sell. Personally, I see major dips as a simple buying opportunity.

Works Cited

Bureau of Labor Statistics. “United States Energy Inflation.” Tradingeconomics.com, tradingeconomics.com/united-states/energy-inflation.

Chinn, Menzie. “Inflation: January 2024 | Econbrowser.” Econbrowser.com, 13 Feb. 2024, econbrowser.com/archives/2024/02/inflation-january-2024.

Council of Economic Advisers. “Both Sides of the Ledger: Wage Growth Beating Price Growth Now for 15 Months in a Row | CEA | the White House.” The White House, The White House, 12 June 2024, www.whitehouse.gov/cea/written-materials/2024/06/12/both-sides-of-the-ledger-wage-growth-beating-price-growth-now-for-15-months-in-a-row.

Iacurci, Greg. “Is the U.S. Stock Market Too “Concentrated”? Here’s What to Know.” CNBC, CNBC, July 2024, www.cnbc.com/2024/07/01/how-magnificent-7-affects-sp-500-stock-market-concentration.html.

Stepek, John. “Don’t Panic: Here’s What’s behind Today’s Sell-Off.” Bloomberg.com, Bloomberg, 5 Aug. 2024, www.bloomberg.com/news/newsletters/2024-08-05/don-t-panic-here-s-what-s-behind-today-s-sell-off.

Wheat, Chris, and George Eckerd. “The Changing Demographics of Retail Investors.”  Jpmorganchase.com, 2023, www.jpmorganchase.com/institute/all-topics/financial-health-wealth-creation/the-changing-demographics-of-retail-investors.

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