August 2024 Stock Market Sell-off: Which Hedges Worked?

Summary

The video discusses the stock market's recent selloff, highlighting the dominance of the 'Magnificent 7' tech stocks and the impact of the Bank of Japan's unexpected interest rate hike on global markets. It delves into the carry trade's role in volatility, the US Federal Reserve's policy, and the importance of risk management. The script offers insights into safe investments like money market funds and UK gilts, emphasizing the need to reassess asset allocation and risk tolerance in response to market fluctuations.

Takeaways

• 📉 The script discusses the stock market selloff in 2024 and how it was triggered by the Bank of Japan's unexpected interest rate hike, leading to a global selloff due to the unwinding of the carry trade.
• 📈 It highlights the dominance of the 'Magnificent 7' tech stocks in the US stock market, particularly in NASDAQ and S&P 500, and their significant returns since 2020, which were partly responsible for the market's complacency.
• 🗨️ The video emphasizes the importance of reassessing risk management and asset allocation in response to market volatility, using the recent market wobble as a learning opportunity.
• 💹 The script points out that money market funds were resilient during the selloff, offering low volatility and acting as a safe investment compared to developed market index funds.
• 💷 It mentions the role of UK gilts as a safe investment, providing a hedge against market downturns with little risk and being tax-efficient for UK investors.
• 🌐 The video explains how having a 'risky' currency like Sterling can act as a built-in hedge for UK investors during market selloffs, as currency movements can offset some losses.
• 📊 The script provides insights into the performance of various asset classes during the selloff, noting that US Treasury funds and long-duration government bond funds acted as effective hedges.
• 🤔 It raises the question of the optimal asset allocation, considering factors such as risk appetite, risk capacity, and investment horizon to balance safe and risky investments.
• 📊 The 'bucket approach' to retirement planning is mentioned, suggesting how to allocate investments based on when the funds will be needed, with a mix of safe and risky assets.
• 📉 The video warns against becoming too risk-averse after a selloff, as it could hurt long-term returns, emphasizing the historical outperformance of stocks over bonds.
• 📈 It concludes by encouraging viewers to use the market wobble as an opportunity to reassess their portfolios and risk appetite, rather than waiting for a major crash to make changes.

Q & A

What was the state of the stock market in 2024 until August?

The stock market in 2024 until August was characterized by a state of complacency with very good returns, and people were expecting this trend to continue.

Who are the 'Magnificent 7' mentioned in the script, and why are they significant?

The 'Magnificent 7' refers to seven dominant companies in the US Stock Market, particularly influencing the NASDAQ index and S&P 500. They have been significant due to their spectacular returns, especially driven by the AI narrative.

What was the initial trigger for the global selloff mentioned in the script?

The initial trigger for the global selloff was the Bank of Japan's decision to raise interest rates to 0.25%, which was more than what people expected, affecting the carry trade strategy many investors were using.

What is the carry trade, and how did it contribute to the market volatility?

The carry trade is a strategy where investors borrow cheaply in Yen, convert it to another currency with a higher interest rate, and invest in assets like US Mega cap tech stocks. This strategy contributed to market volatility when currency volatility increased, leading to margin calls and rapid unwinding of trades.

How did the Bank of England's actions affect the market?

The Bank of England's decision to cut interest rates affected the market by reducing the growth rate of money market funds, which in turn influenced the real return above inflation for these funds.

What role did UK gilts play during the market selloff?

UK gilts, being government bonds, acted as a safe investment and hedge against the market selloff. They increased in value when equity markets sold off, providing a safe haven for investors.

How did the US Federal Reserve's actions impact the market?

The US Federal Reserve's decision not to change interest rates and its optimistic outlook initially seemed to stabilize the market. However, the subsequent release of employment data that signaled a potential recession led to increased panic and a selloff.

What is the significance of the 'S' rule in the context of the US economy?

The 'S' rule is a signal that often indicates a US recession when unemployment picks up sufficiently. It did not directly signal a recession in this case, but it did show a weakening in the US jobs market.

Why did gold, typically considered a safe haven, sell off during the market turmoil?

Gold sold off during the market turmoil, possibly due to the specific factors affecting the market, such as the unwinding of carry trades, rather than a general increase in risk aversion that typically drives demand for gold.

What is the 'bucket approach' to portfolio allocation mentioned in the script?

The 'bucket approach' to portfolio allocation involves dividing one's portfolio according to when the money will be needed, with short-term needs going into safe investments and long-term funds going into riskier assets like equities.

What are the three factors investors should consider when deciding their portfolio allocation?

The three factors investors should consider are risk appetite (emotional capacity to weather losses), risk capacity (economic ability to withstand losses without changing lifestyle), and investment horizon (the length of time before needing the invested funds).

Outlines

00:00

📉 Stock Market Selloff and Risk Management

The script discusses the aftermath of a stock market selloff, emphasizing the importance of reassessing risk management and asset allocation strategies. It characterizes the market's state up to August 2024 as complacent, with unexpectedly good returns, but then a shock due to the 'Magnificent 7' stocks' dominance, especially in tech sectors like NASDAQ and S&P 500. The selloff was triggered by the Bank of Japan's unexpected interest rate hike, affecting the global market due to the carry trade's unwinding. The video aims to analyze what could have been done to protect wealth during such events and suggests that while some believe the worst is over, the impact on major indices and tech stocks has been significant, causing a reevaluation of market stability.

05:01

💼 Safe Investments During Market Volatility

This paragraph focuses on identifying safe investments that could mitigate losses during market selloffs. It highlights money market funds as resilient, low-volatility investments, similar to cash but with slightly higher returns. The script contrasts these with the performance of a developed market index fund during the same period. It also discusses UK gilts as a safe investment, being government bonds that offer tax efficiency and are considered very secure. The paragraph explains how gilts can act as a hedge against equity market downturns, especially when there isn't a systemic issue like high inflation. It also touches on the benefits of having a 'risky currency' like Sterling, which can act as a natural hedge due to its tendency to weaken during market stress, thus benefiting investors when converting global investments back to their domestic currency.

10:02

🌐 Global Asset Performance and Hedging Strategies

The script examines the performance of various asset classes during market selloffs, identifying US Treasury funds as the best performers, with long-duration bonds like TLT showing the most significant gains. It points out that assets like Bitcoin, NASDAQ, and QQQ trackers experienced substantial losses, while gold, typically a safe haven, also saw a decline. The paragraph also notes that hard currency emerging market bonds and US junk bonds did not sell off as much, indicating no significant credit quality deterioration. For premium members of the pensioncraft website, a US valuation tool is mentioned, which forecasts earnings and price-to-earnings multiples for the S&P 500, suggesting that the US market still appears expensive even after the selloff and may be prone to further declines.

15:02

🔢 Balancing Risk and Return in Portfolio Allocation

The final paragraph addresses how investors should balance the allocation of safe and risky assets in their portfolios. It suggests considering three factors: risk appetite, risk capacity, and investment horizon. The 'bucket approach' is introduced as a strategy to allocate assets based on when the funds will be needed, with short-term needs going into safe investments and long-term funds primarily into equities for higher returns. The script warns against becoming overly cautious due to market selloffs, as this could negatively impact long-term returns. It emphasizes the historical outperformance of stocks over bonds and encourages investors to manage their fear and reassess their portfolio allocation in light of market events.

Keywords

💡Stock Market Selloff

A stock market selloff refers to a situation where there is a significant decline in stock prices over a short period of time. In the video, it is the central event that prompts a discussion on risk management and asset allocation. The script mentions a 'nasty shock' that occurred in 2024, which disrupted the complacency of a market that had been experiencing good returns.

💡Complacency

Complacency in the context of the video refers to a state of being self-satisfied and unaware of potential risks. It is used to describe the market's attitude prior to the selloff, where investors were lulled into a false sense of security by the good returns, not anticipating the subsequent downturn.

💡Magnificent 7

The 'Magnificent 7' in the script represents a group of seven dominant companies in the US Stock Market, particularly influential in indices like NASDAQ and S&P 500. The term is used to illustrate the concentration of market influence and the significant returns these companies had been generating, as seen with Nvidia and Tesla's annualized returns.

💡Carry Trade

A carry trade is an investment strategy where an investor borrows money in a currency with a low interest rate and invests it in another currency with a higher interest rate. In the video, the carry trade is highlighted as a contributing factor to the market selloff, especially when the Bank of Japan unexpectedly raised interest rates, causing a rapid unwinding of these trades.

💡Currency Volatility

Currency volatility refers to the fluctuations in the exchange rates between different currencies. In the script, it is mentioned as a critical factor that can affect carry trades, leading to margin calls and the need to unwind trades, which in turn can cause market volatility.

💡Risk Management

Risk management in the video is the process of identifying, assessing, and prioritizing potential risks to minimize or avoid negative impacts. It is a key theme as the video discusses how investors can reassess their risk management strategies in light of market wobbles and selloffs.

💡Asset Allocation

Asset allocation is the process of distributing investments across different asset classes, such as stocks, bonds, and cash, to optimize the risk-reward profile of a portfolio. The video emphasizes the importance of reassessing asset allocation in response to market changes to protect wealth and manage risk.

💡Money Market Funds

Money market funds are a type of investment fund that invests in short-term debt securities with high credit quality. In the video, they are presented as a safe investment that has been resilient during the market selloff, offering low volatility and a cash-like investment.

💡UK Gilts

UK Gilts are government bonds issued by the UK government. They are considered a safe investment and are used in the video as an example of a hedge against market volatility. The script discusses their tax efficiency, lack of currency risk, and safety as a long-term investment.

💡Risk Appetite

Risk appetite is an investor's willingness to take risks with the potential of losing some or all of the invested capital. The video discusses how an individual's risk appetite, along with their risk capacity and investment horizon, should inform their asset allocation strategy.

💡Investment Horizon

Investment horizon refers to the length of time an investor plans to hold an investment before needing to access the funds. The video uses this concept to explain how a longer investment horizon can allow for more risk-taking in a portfolio, as there is more time for investments to recover from potential downturns.

Highlights

The video discusses how to reassess risk management and asset allocation after a stock market selloff.

2024 until August was characterized by complacency with good returns, followed by a market shock.

The 'Magnificent 7' tech stocks became very dominant in the US Stock Market, particularly influencing the NASDAQ and S&P 500 indices.

Annualized returns for some of the 'Magnificent 7' stocks like Nvidia and Tesla have been spectacular since 2020.

The Bank of Japan's unexpected interest rate hike triggered a global selloff due to the carry trade unwinding.

Carry trade involves borrowing in Yen and investing in higher interest rate currencies or assets, which became risky with increased volatility.

The TOPIX index in Japan suffered its worst one-day fall ever, highlighting the rapid impact of the carry trade unwinding.

Investors in mega-cap tech stocks in the US had to sell, contributing to the market downturn.

The Federal Reserve's inaction on interest rates and a rosy economic outlook contrasted with a subsequent jobs market weakness.

The S&P 500 and NASDAQ indices saw significant selloffs, impacting global index investors.

Money market funds and UK gilts (government bonds) acted as safe investments during the market selloff.

UK gilts, especially long-duration ones, rose in value as a reaction to equity market fear.

The weakening of Sterling during market fear acts as a built-in hedge for UK investors with global investments.

US Treasury funds performed well during the selloff, with long-duration bonds like TLT gaining the most.

Assets like Bitcoin and gold did not act as safe havens during the selloff, contrary to expectations.

The video emphasizes the importance of balancing a portfolio between safe and risky investments based on risk appetite, capacity, and investment horizon.

The 'bucket approach' to retirement planning is mentioned as a strategy for asset allocation based on when funds will be needed.

The video concludes by advising viewers not to become overly cautious due to market selloffs, to avoid hurting long-term returns.

Transcripts

in the aftermath of a stock market

selloff we're often left wondering too

late whether we could have protected our

wealth so in this video we'll look at

what would have worked this time around

and how to use this Market wobble to

reassess our risk management and asset

allocation if I was to characterize 2024

until August that is I'd say it was in a

state of complacency returns have been

very good and we were expecting that to

continue however what we actually got

was a bit of a nasty shock and of course

people have been warning about this

coming for some time if you look at the

Magnificent 7 they've become very

dominant in the US Stock Market

particularly the NASDAQ index but even

in the S&P 500 and if you own a global

Index Fund again they're very dominant

in that too and the returns that we've

been seeing for some of the Magnificent

Seven stocks pushed up by the AI

narrative had been spectacular so if we

annualize the returns and this is since

2020 you can see that some of these

stocks like Nvidia are up by 100% per

year and Tesla was up by over 50% per

year and even the worst performing of

The Magnificent 7 Amazon was up 16% per

year so inevitably something went wrong

and surprisingly it came out of Japan at

least initially the bank of Japan which

is had negative and then zero interest

rates while every other bank around the

world has been raising interest rates to

combat inflation finally got around to

raising interest rates and it did so by

more than people expected so it

increased rates to

0.25% now the reason why that spread

into a global selloff was because many

investors have been doing something

called the carry trade you could borrow

very cheaply in Yen convert the yen to

another currency which has a higher

interest rate Mexico is one example

where the interest rate is above 11% or

you could buy us do and buy us Mega cap

tech stocks at the same time you lock in

the currency conversion rate with

something called a currency forward now

everything's fine until currency

volatility starts to pick up because

then this leverage trade might suffer

margin calls and you have to unwind the

trade and unwind other trades in order

to get yen to pay off the margin nobody

knows exactly how much was in carry

trades globally one estimate puts it at

about half a trillion dollars but it was

a very crowded trade and when you have

to unwind a very crowded trade very

rapidly it causes volatility now as I

make this video some analysts think that

the worst is over that the carry trade

has been largely Unwound others say that

we still have further to go but if we

look at the effect on the epicenter

which was of course the Japanese market

and we look at the topics which is the

Japanese stock index you can see that

they suffer their worst fall ever ever

in one day markets fell by over 12% now

it's worthwhile mentioning that the

following day the topics index had its

second best ever return so this is

another example of why it's usually not

a good idea to sell after markets have

fallen often these very large positive

and negative returns go hand inand now

investors who' done the carry trade

investing in mega cap tech stocks in the

US would have had to unwind that and

sell those stocks and that pushed down

prices then we had another shock when

the Federal Reserve the US Central Bank

didn't do anything to its interest rates

and it painted a pretty Rosy picture for

the US economy a soft landing and

everything seemed fine that was on July

the 31st and then on August the 2nd the

Bureau of Labor Statistics in the US

published its employment situation

summary and that painted a picture which

wasn't quite as rosy unemployment had

picked up sufficiently to trigger the S

rule which often signals a US recession

although Claudia arm says not in this

case but it did show a weakening in the

US jobs market and many investors felt

that the Fed was behind the curve and

this just exacerbated the feeling of

panic in markets so if we look at

returns for the Magnificent 7 as I make

this video you can see that some of them

have sold off very significantly since

July the 26th which is just before all

this kafuffle kicked off Tesla Nvidia

Amazon all three of those stocks are

down by over 10% and because Global

index investors such as myself are so

heavily concentrated in those Mega cap

tech stocks we've all suffered a draw

down as a result of this destabilization

of equity markets the worst Peak to TRW

fall was around 6% but still it was a

rude awakening because we'd grown

accustomed to markets that just steadily

rise now if you are wondering how you

can make sense of all this macroeconomic

data central bank policy changes and how

it affects markets it's something we

publish for free and you can have this

delivered to your inbox every Friday we

also try to make it amusing people tell

us that we succeed here for example

we're talking about what the bank of

Japan did but also the bank of England

and its effect on markets so if you do

want to learn more about that it's very

easy just go to our website pensioncraft

tocom SL newsletter and you'll find a

link so you can subscribe in the

description below but what is useful is

we can use this little market wobble to

give us a sense of what was safe in

other words what kind of Investments

would have mitigated our losses and

presumably would mitigate losses if we

get an even bigger selloff which will

happen eventually now starting with the

safest investment the money market funds

have been particularly resilient when it

comes to this big selloff and that's

because they're very cash-like they're

not exactly the same as cash they don't

have have the same protections but they

are very low volatility Investments so

the red line you can see at the top of

this graph that's a money market fund in

the UK it's an accumulation money market

fund I've talked about it before and you

can see how low the volatility is and

when we set that alongside a developed

market index fund the one in my core

portfolio vhg you can see the contrast

there in terms of volatility csh2 just

gradually increases by. 3% over this

short time period whereas Global markets

are down by about 4% now of course the

bank of England has cut interest rates

so what was a 5.2% rate of growth of

this money market fund and others will

fall to 5% but it's going to be a fairly

slow process by which the bank of

England Cuts rates so it Still Remains

the case that you get very good real

return above inflation for money market

funds in the UK and in the US and if you

want to shelter your capital from Market

pullbacks that's a reasonable place to

preserve your Capital another safe

investment which I've made a lot of

videos about is UK guilts these are UK

government bonds where effectively

you're buying slices of UK government

debt in return for giving your money to

the government and funding it you're

paid a small interest rate and it's very

tax efficient if you hold it outside an

Isa or a sip because you don't pay

capital gains on UK Guild guilts but

another benefit of UK guilts for UK

investors at least is that you don't

have any currency risk it's all

denominated in Sterling plus they're

very safe the UK government has not

defaulted in living memory and if you

hold them to maturity you don't have to

worry about interest rate risk either

because they always mature at 100 so

this is a hedge which you're paid to

hold and where you take very little risk

so I've shown here three UK guilts one

which materials in year that's T25 one

which materials in a decade that's t34

and one which materials in 40 years

that's TG 65 and again these are laid

alongside a global Index Fund vhg for

comparison now notice how when vhv sells

off these three bonds all rise in value

and the one with the longest maturity

increases the most this is a classic

riskof reaction of government bonds when

people are scared

they sell their Equity they buy bonds

and that pushes up the prices and it

pushes the yields down and the bonds

which usually gain the most are the ones

with the longest duration those are also

the ones which have the most volatility

as a bond matures as it gets closer to

maturity its volatility Falls to zero

but for very long duration bonds like TG

65 the volatility is almost Equity like

but when people are scared those are

usually the bonds which increase in

value the most but you're probably

thinking wait a minute I've been told

that bonds don't hedge Equity anymore

well that's only if there's a factor

which affects both of them negatively

like very high inflation which is what

we saw in 2022 if it's just run of the-

Mill fear of things like a carry trade

being Unwound then bonds are actually a

very good hedge for Equity so what we

saw for all three of those bonds is as

Equity sold off they Rose in value and

then as equity you recovered they fell

back to where they were previously so

they offered a hedge now as UK investors

we have something which is actually very

useful built into our currency which is

that it's not seen as a safe haven it's

a risky currency that means that when

people are scared when we have these

riskof moves in markets Sterling weakens

versus the dollar and because most of

our investments AS Global index

investors are in dollars the US Market's

huge that weakening of Sterling means

that you actually weaken less because

when you convert back to Sterling you

get more Sterling for every dollar so by

having a risky currency we have a kind

of built-in hedge when people are scared

to illustrate that let's look at that

vhg fund alongside another developed

Market tracker but this one is currency

hedged so youve removed the effect of

Sterling notice how for the Sterling

hedge fund with tick up IG gwd the

selloff was much larger and that's

because of the weakening of Sterling

which was about 2% over the course of

this selloff now of course on the upside

Sterling pulls in the opposite direction

and it reduces our return as it

strengthens but overall the effect is to

reduce or dampen the volatility of our

Global index Investments how about if we

look across all asset classes and we do

it all in dollars well in this case you

can see that for the US as well treasury

funds US Government bond funds perform

the best and they gained the most in

value during the sell-off the funds

which have the greatest maturity like

TLT which is 20year plus maturity us

treasuries that gained in value the most

it Rose by just under 2% intermediate

bonds gained a little bit less and short

duration US government bonds even less

than that but all three of those were

very effective Hedges against the

selloff there were no surprises about

the things which sold off the most

Bitcoin was down about 15% it behaves

very much like a leveraged NASDAQ index

tracker the NASDAQ also the QQQ tracker

tracks NASDAQ that was down by 12% and

the S&P was down by 8% what's kind of

interesting is that gold which is

usually a safe haven sold off by about

3% so it didn't gain in value as Equity

markets were selling off and while

emerging market stocks certainly sold

off you can see that the Vanguard emerg

in markets ETF was down by over 6% hard

currency Emerging Market bonds however

which are denominated in dollars didn't

sell off much at all what's also

interesting is that junk Bonds in the US

which show that there's some kind of

credit problem didn't sell off because

there wasn't really a deterioration of

credit quality for us companies now for

our pensioncraft tocom website premium

members we offer these trackers one of

which is a US valuation tool what this

does is it shows you the forecast

earnings for the us over the next year

and it multiplies it by various numbers

and that's to show you what the price of

the S&P 500 would be if it was say 19

times forward earnings so if the forward

earnings are about

$260 the 19 times that would be just

over 5,000 for the S&P now that's the

average the 5-year average price to

earnings multiple for the S&P so when

we're above that you know that the S&P

is relatively expensive compared to

where we've been over the last 5 years

the reason why we use the forward price

to earnings multiple is that it factors

in a lot of the optimism about future

earnings and it's not backward looking

stocks typically are forward-looking so

this measure is as well so even

factoring in that optimism about forward

earnings the US is still looking

expensive right now even after that

selloff it's above the 5e average is

above the 10e average forward price to

earnings multiple and so that means that

we could get further sell-offs so all of

that begs a question how much of our

portfolio should be safe and how much

should be risky I think the key thing as

investors is to combine three different

factors when considering how much risky

stocks to have in our portfolio the

first one is risk appetite this is your

emotional capacity to weather a loss if

markets Fall by 30% would you be an

emotional wreck some people I know can

just shrug it off others get really

upset because this is their life savings

and they get distroyed understandably

the second factor is your risk capacity

what's your economic ability to weather

a loss without suffering a change in

your quality of life if it's money

you're not going to need for some time

then your portfolio could make a big

loss and as long as it recovers by the

time you need the money it won't

materially affect your life even in

retirement some people have excess

savings they're in a very lucky position

and even if markets fall it won't affect

their quality of life for the vast

majority of us however we don't have

that kind of risk capacity and that in

turn reduces the amount of losses we can

absorb and the amount of risk we can

take in our portfolio the final

consideration is investment Horizon if

you are going to be investing for a very

long period of time before you need the

money then you can take more risk cuz

it's very likely that stocks will

recover by the time you actually need

the money so the sweet spot for your

asset allocation sits in the middle of

that vend diagram what kind of losses

can you absorb emotionally what kind of

losses can you absorb economically and

how long will you be invested for in a

video called retirement planning are you

on track I analyze this using What's

called the bucket approach you'll find a

link to that video by the way in the

description below but the idea here is

you split up your portfolio according to

when you'll need the money anything you

need over a short period of time then

you put that into non- crashy

Investments safe Investments things like

Cash Money Market funds short duration

government bonds or single guilts that

you hold to maturity where the maturity

of course is less than 5 years now

obviously you don't want those things to

crash before you need the money so

that's why you choose low volatility

Investments so almost all of that will

go into the safe bucket at The Other

Extreme money that you're not going to

touch for 10 years more of that can go

into equity in fact the vast majority of

it probably would go into Equity it

doesn't have to be complex it can just

be a global Equity Fund or you can have

more than one fund Regional funds but

Equity will give you that good long-term

return yes it'll be volatile but because

it'll be there for a long period of of

time you don't really care then for the

intermediate bucket between 5 and 10

years you'd have some mix of the two sum

in the safe bucket sum in a risky bucket

according to your risk appetite however

there's a word of warning here which is

don't let these sell-offs scare you so

much that you become too cautious too

risk averse because that's going to hurt

your long-term returns remember that

stocks beat bonds by about four or 5%

every year if you look at this report

which was published by credit Swiss in

2023 the same report is now published by

UBS it showed the average long-term

returns in the US and the UK both before

inflation subtracted and after here I've

shown the nominal returns which don't

consider inflation notice how much more

stocks have returned on average in both

countries relative to bonds it's 4% or

more so if you do go too cautious and

you end with too many bonds or even

money market funds you will on average

underperform so you've got to learn to

conquer your fear so I hope this video

has allowed you to take this little bit

of a market wobble it wasn't huge and

reassess your risk appetite because the

time when you want to rebuild your

portfolio and change your allocation is

not just after a crash or at least not

after a big one so use this to learn

what works what's likely to preserve

your capital and reallocate accordingly

if you need to and don't forget if you

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