Market insights and analysis

By Will Hubbard

Market snapshot

•  Stocks: Stocks rallied after a rough start to the week, with the CBOE Volatility Index reaching levels not seen since COVID lockdowns.

•  Bonds:  The 10-year bond yield rose to 3.94%, causing prices to fall as unemployment claims came in below expectations, stabilizing equities and suggesting a healthier labor market. Bond prices remained under pressure, particularly in U.S. Treasurys, while high-yield bonds rallied amid a risk-on sentiment.

•  Gold: Gold fell 0.49% to $2,431.32 per ounce, influenced by moves in the U.S. dollar and investor sentiment.

•  Market indicators and outlook: Market regime indicators show the market is in a Normal economic environment stage, which is historically positive for stocks, bonds, and gold but with a substantial risk of a downturn for gold. Normal is one of the best stages for stocks, with limited downside. Volatility is High and Rising, which favors stocks over gold and then bonds.

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The week began with a sharp decline in equities, but markets largely rallied as the week progressed, offsetting the initial losses. The Dow Jones Industrial Average ended the week down 0.56%, the S&P 500 dipped 0.02%, and the NASDAQ lost 0.17%. The 10-year Treasury yield rose to 3.94%, pushing prices higher, while gold fell 0.49% to $2,431.32 per ounce.

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Stocks

Volatility dominated last week as investors and traders watched the S&P 500 open 3% lower Monday morning. The CBOE Volatility Index, known as the VIX—or “fear index,” peaked at crisis levels near 65 before settling in the mid-30s by late Monday morning.

Speculation was rampant, and the word “recession” was thrown around as if the market’s downward trend was certain. While a recession may be on the horizon due to a recent unemployment spike and expectations that the Federal Reserve will cut rates in September, the consensus is that the unwinding of the popular yen/dollar carry trade caused the brief spike in volatility last week.

Before jumping into the week’s economic data, let’s review what a carry trade is. Carry trades involve borrowing at a low interest rate and investing at a higher rate. The Bank of Japan’s interest rate had been below 0.1% since 2008 and hadn’t been much higher than that over the last 100 years. This allowed U.S. investors to borrow in yen, invest in U.S. dollars, and pocket the difference.

This changed quickly when the Bank of Japan raised rates to 0.25% amid the expectation that the Fed would cut rates. The narrowing interest-rate differential, combined with a strengthening yen, forced traders to unwind losses as market volatility increased and borrowing costs to hold the trade rose.

The following chart shows the yen appreciating relative to the U.S. dollar as the Bank of Japan raised rates and the Fed signaled its intent to cut rates.

On its own, the reversal of a trade isn’t necessarily an issue, but to make it profitable and worthwhile, traders must borrow a lot of funds, creating financial leverage. Carry trades are generally profitable and fairly stable, but this stability can lead to unpredictability during a crisis. Financial leverage can exacerbate downturns and create more volatility.

The longer the market feels safe and stable, the more investors and traders tend to anchor future expectations to recent experiences, known as recency bias. This false sense of security can lead to trades or investments that might be unsuitable for their investment risk profile, as traditional software often underestimates the true risk because of recent performance. What we saw last week was a bit of complacency and optimism in the face of mild uncertainty. Last Monday, investors quickly pulled back on fears that the global carry trade unwinding would affect other risk assets, while geopolitical uncertainty kept investors on edge.

Turning to economic data, last week was light on releases. Key announcements were the Institute for Supply Management (ISM) Purchasing Managers Index (PMI) report and unemployment claims. PMI came in slightly better than expected at 51.4, indicating expansionary expectations from producers. Unemployment claims came in lower than expected, offsetting concerns about the unemployment spike reported on August 2. The market rallied on this news through the end of the week.

The bottom line is that the market remains in a complacent state. The VIX’s unusually large spike and return to near-normal levels within a week show how on edge investors are. We’re dealing with concerns around monetary policy; its impact on inflation and unemployment in an election year; and geopolitical tensions such as the war in Ukraine, Israel’s conflicts, China’s actions toward Taiwan, and North Korea’s missile tests. Market participants should know that bull markets and rallies can last a long time, and the tipping point may not come soon. Therefore, preparation, prudence, and taking emotions out of the equation are the best risk-management techniques for investing, something that active risk managers can deliver.

Bonds

The 10-year bond yield rose 0.15% to 3.94% last week after briefly surpassing 4%, causing prices to fall following the previous week’s rally.

Prices initially rose on the weaker-than-expected unemployment data from August 2, which increased the likelihood of a rate cut. However, last week’s decline was a reaction to new lower-than-expected unemployment claims, which stabilized equities and suggested a potentially healthier labor market.

Bond prices remained under pressure last week, especially in risk-haven assets like U.S. Treasurys. As equity prices rebounded, high-yield bonds also rallied amid a risk-on sentiment that capped the week.

The adage “Don’t fight the Fed” still holds. The Fed has been transparent about its intentions, so unless there’s a compelling reason to deviate, it seems prudent to follow their guidance while being prepared for any necessary adjustments.

Gold

Last week, gold dipped 0.49%, dropping from $2,443.24 to $2,431.32 per ounce. The initial decline came early in the week as the U.S. dollar strengthened against Treasury yields. As volatility persisted, investors began reallocating to gold in response to ongoing uncertainty about China’s economic slowdown.

Toward the end of the week, gold rallied, but its performance remains influenced by movements in the U.S. dollar, Treasury yields, and investor sentiment about global economic risks.

Flexible Plan Investments is the subadviser to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction 11 years ago to track the daily price changes in the precious metal.

The indicators

The very short-term-oriented QFC S&P Pattern Recognition strategy started last week 0% long, moved to 40% long at Monday’s close, increased exposure to 110% on Tuesday, reduced exposure to 80% on Wednesday, and remained there for the rest of the week. Our QFC Political Seasonality Index was in its risk-on posture throughout the week. (Our QFC Political Seasonality Index is available—with all of the daily signals—post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.)

Our intermediate-term tactical strategies have varied in their degree of defensive positioning. The key advantages these strategies offer to investors are their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started last week 60% long, reduced exposure to 40% on Monday’s close, and dropped exposure to 20% long on Friday’s close. Our Systematic Advantage (SA) strategy started last week 60% long, increased exposure to 90% long on Monday’s close, dropped back to 60% long on Tuesday’s close, bumped back up to 90% long on Wednesday, and remained there for the rest of the week. Our QFC Self-adjusting Trend Following (QSTF) strategy made some moves last week. It started in cash, moved to a 160% long on Tuesday, and remained there throughout the week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model was long risk-on positioning all week. Most of our Classic accounts follow a signal that will allow the strategy to change exposure in as little as a week. A few accounts are on more restrictive platforms and can take up to one month to generate a new signal.

FPI’s Growth and Inflation measure is one of our Market Regime Indicators. It shows that we are in a Normal economic environment stage (meaning a positive monthly change in prices and a positive monthly change in GDP). Historically, a Normal environment has occurred 60% of the time since 2003 and has been a positive regime state for stocks, bonds, and gold. Gold tends to outpace both stocks and bonds on an annualized return basis in a Normal environment but carries a substantial risk of a downturn in this stage.

Our S&P volatility regime is registering a High and Rising reading, which favors equities over gold and then bonds from an annualized return standpoint. The combination has occurred 23% of the time since 2003. It is a stage of high risk for both equities and gold.