Market sell-off lessons from the Cold War

Yesterday's market falls mirrored those of a month ago, when things (briefly) got a bit scary. Market sell-offs always are, which only compounds the scariness; with enough fear in the air, drops become self-fulfilling, even precipitous.

Over five trading days, the MSCI World index lost 7.3 per cent. The tech-rich Nasdaq suffered worse. But the damage was limited. Two weeks later, prices were back at their pre-sell-off levels.

The catalysts for the drop were weaker than expected US job creation and manufacturing sentiment reports, which sparked concerns that the world’s most important economy was heading for recession, aided by an overly restrictive Federal Reserve.

But while neither data point was a total shock, the news quickly curdled, with nerves around Japanese interest rates, the latest spike in Middle East tensions and traders keen to limit their exposures ahead of their summer holidays. Investors awoke on Monday 5 August to reports of frenzied selling in Tokyo, and volatility levels not seen since March 2020. Ordinarily, digestible developments suddenly had the making of a market crash.

Post-mortems have since failed to pinpoint obvious liquidity issues. There was no unforeseeable world-wide computer glitch of the kind that brought Windows systems to their knees in mid-July. Nor did any globally important financial actors experience an idiosyncratic meltdown.

Instead, blame has settled on the sudden unwinding of the yen carry trade. In recent years, lots of professional investors have borrowed cheaply in the Japanese currency, invested the cash in higher-yielding (typically non-Japanese) assets such as US tech stocks, and banked the difference.

Like many market phenomena that suddenly go ‘pop’, the trade involves leverage, which means more risk. As the yen climbed against the dollar in July, hedge funds and other short-term momentum traders were forced to sell to raise cash, lest they hit portfolio risk limits. Why these mechanics matter to ordinary retail investors is that effects on price are real, regardless of their brevity.

According to some commentators, sudden sell-offs will become more frequent – at least relative to the unusual market calm that characterised much of the post-global-financial-crisis (GFC) era. If we are back in the world of variable and more responsive fiscal policy, then that means more volatility.

This means investors may need to think and act more like Stanislav Petrov, a Soviet Air Defence engineer who in 1983 correctly identified the imminent US attack detected by an early warning system as a false alarm. By waiting for corroborating evidence rather than escalating the alert, Petrov defied protocol. But he also prevented a retaliatory strike and possible nuclear war.

Although the stakes are lower, this is a key issue with stop-loss orders – especially those set below 10 per cent. While widely touted by trading platforms, automated selling swaps human judgment and reasoning for a computer’s speed.

What, then, is the ordinary investor to do? To some, higher volatility will lessen the appeal of stocks. That’s fine: not everyone likes rollercoasters. But for those who need or want to commit to risk assets and the primacy of fundamentals, it’s worth looking at precedent.

Between the start of 1988 and the end of 2006 (and before the GFC begat ZIRP – zero interest rate policy) there were 221 trading days when the MSCI World Index fell by at least 1.5 per cent. In the week that followed these sell-offs, average returns of 0.12 per cent were three basis points below the average of all days. But after a month, average returns of 1.3 per cent were 68 basis points ahead of the entire trading history, and a whole percentage point up after both three and six months.

Back when markets jumped around more, sitting tight was often the right move. It was the right move this summer. It will often be the right move again in the future.