Stocks have been on nothing short of a wild ride in August.
With valuations already elevated, there were a handful of negative surprises that seemingly all landed at once, which were then capped off by concerns about the unwinding of the Japanese carry trade.
And while we’re still working our way through the early-August retreat, it’s becoming clearer by the day that the bull market in stocks is not yet over.
So let’s take a look back at the events that brought us here and see what lessons we can take away from them going forward.
Let’s Start with Small Caps
For two weeks after the June 11 CPI print, small-cap stocks were the talk of the town, referenced across social media accounts and in major media outlets, many of which hadn’t even glanced in the direction of small-cap stocks for months.
The Fed Meeting: Off to a Strong Start …
The stars seemed to be aligning for the small-cap rally to stay alive through the Fed’s meeting on Wednesday, July 31.
The broad market was up through the day and the S&P 600 Small Cap Index hit another new high, closing at its highest level since late 2021.
… Before Breaking Down
But then a couple of surprisingly weak economic reports on Thursday and Friday gave investors reason to question whether the economy could avoid recession. That scenario would likely put the kibosh on the emerging small-cap rally, not to mention send the broad market lower.
Signs of Weakness
First were unemployment claims (for the week ending July 27), which rose by 14K to 249K.
Second was the unemployment component of manufacturing data (national M-PMI) from July, which showed such a steep drop in employment that it was on par with lows from the pandemic and Great Financial Crisis.
Third (Friday morning) was the July payroll number, which missed by a wide margin (June was also revised downward), driving the unemployment rate up to 4.3% versus expectations of 4.1%.
Questioning the Fed
These reports were not a good look, especially since Fed Chair Jerome Powell had just said on Wednesday that the labor market (which the Fed has been trying to cool down) was “normalizing.”
Cue up the “the Fed is behind the curve” calls, along with renewed concerns about recession risk and a retreat in the stock market, which closed out with an exceptionally weak Friday.
To be fair, a few wonky employment numbers, which may well have been affected by Hurricane Beryl (despite what the Bureau of Labor Statistics says), don’t make a trend.
And going into the FOMC meeting there were not a lot of calls for a July cut. Most market observers expected one in September.
Powell’s commentary during Wednesday’s press conference supported that expectation, and all was fine.
The Japanese Carry Trade
Fast forward through the weekend.
Waking up Monday morning it’s fair to say that most of us who follow the market did not expect to see Nasdaq futures pointing to a 5.0% decline.
That scenario was totally out of sync with what we knew about volatility drivers the week prior.
Except for one small detail.
On Wednesday, July 31, while most investors were paying attention to the U.S. Fed, Japan’s central bank decided to raise interest rates.
Yes, that seems weird given that most central banks are cutting. But Japan has been at near zero since 2016. This was only the second interest rate hike in almost 20 years.
The first was in March, when the Bank of Japan (BOJ) went from zero to a range of zero to 0.1%.
July’s hike increased Japan’s target policy rate to 0.25%.
This is relevant because a crowded carry trade – traders buying investments (like the Nasdaq) with cheaply financed funds borrowed in Japanese yen – came under severe pressure as the U.S. stock market declined at the same time as borrowing costs in Japan went up.
That carry trade appears to be one of the main culprits behind the global stock market rout on August 5.
What’s Next?
The initial reaction to the meltdown of the carry trade was calls on Wall Street for an emergency interest rate cut by the Fed.
Those voices have fallen quiet, but the market is currently pricing in a 100% chance of a rate cut at the upcoming September FOMC meeting, with one-third of traders expecting a 50 bps cut and two-thirds anticipating a 25 bps cut.
These numbers vary by the day, but the odds have generally favored the 25 bps “single” cut.
Turning to stocks, it is entirely possible that what was a normal-ish pullback was greatly exacerbated by the coincidental timing of the weak U.S. jobs data releases, the BOJ’s interest rate hike and the subsequent partial unwinding of the carry trade.
The markets have rebounded impressively, but investors remain on edge, and there are still more questions about the strength of the economy than there were heading into August.
But the big-picture drivers of the bull market are still likely to be in place.
We’re talking about improving productivity, strong employment (we think), avoidance of a recession (we think), expectations of less restrictive fiscal policy (i.e., Fed rate cuts in the near future), etc.
The Case for Small Caps
With this backdrop, let’s close things out by returning to where we started, looking at small-cap stocks.
The case for small caps was strong going into the Fed’s July meeting.
Then early August resulted in all but around 3% of the small-cap rally since the CPI print on June 11 being wiped out.
Don’t get me wrong. This was a rough decline.
But the asset class hasn’t fallen apart. Not by a long shot. In fact, since Monday, August 5, small caps have recouped two-thirds of that initial rally.
At the risk of sounding like a market cheerleader, let’s assume the big-picture drivers of the bull market are still in place AND there is now an increased likelihood of accelerated rate cuts.
We just might be in a situation where the case for small-cap performance has gotten stronger, not weaker.
By far the easiest way to get small-cap exposure is to buy an index ETF like the iShares Core S&P 600 Small Cap ETF (IJR).
You can turn up the dial a little if you want by buying a more growth-oriented fund, like the Vanguard Small Cap Growth ETF (VBK).
Both of those options are a good place to start for those new to small-cap investing.
If you’re interested in individual names with significant potential to outperform you can grab a subscription to my small-cap advisory service, Cabot Small-Cap Confidential.
