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Written by: Mary Park Durham
Markets have largely rebounded from the volatility of the past two weeks. The S&P 500 has recovered 3.0% after a 4.8% decline, U.S. Growth equities have risen 4.3% following a 5.5% drop, and the VIX has settled at 20.7, after spiking to 55.1, its highest level since March 2020. However, investors are still pondering what caused the sudden sell-off and if more volatility is expected.
To begin with, equity volatility and pullbacks are quite common, and since 1980, the S&P 500 has experienced average intra-year declines of 14.2%. However, there were some specific factors that contributed to the recent sell-off. Investors should consider the following:
- Elevated valuations: The U.S. equity rally has been powerful and fast, with stocks surging 35.8% between October 2023 and mid-July 2024 while achieving numerous all-time highs. The rally has also been very narrow, with a handful of names soaring on the back of AI-related excitement. With AI still in its infancy and being somewhat speculative, the rise was largely led by multiple expansion, with the top 10 names in the S&P 500 trading at 34.8x forward earnings at their richest, bringing up multiples for the whole index. This left markets highly susceptible to pullbacks in response to less-than-perfect big tech earnings news or disappointing economic data.
- Increased sensitivity to economic data releases: Since the pandemic, markets have become more reactive to incoming economic data due to an increased focus on rates, which are a variable in both valuations and earnings expectations. For most of this cycle, inflation has been in focus. For example, in 2022, markets moved by 1% or more in either direction 58% of the time following CPI prints, whereas in the five years prior, markets only moved that much 13% of the time. While investor attention has recently shifted toward the labor market, markets will no doubt continue to care about both sides of the Fed’s mandate.
- Technical factors: Low interest rates in Japan and in the U.S. before 2022 emboldened institutional and retail investors to use more leverage. It is estimated that hedge fund leverage use is at 2.7x, close to the peak reached in 2017 and higher than 98% of the time recorded. Low rates also popularized the Yen carry trade that exacerbated some of last week’s selloffs.
Looking forward, the outlook has largely improved. The recent sell-off put downward pressure on valuations and our investment bank estimates that 75% of the Yen carry trade is unwound, with the use of leverage likely to decrease going forward as global rates settle at higher levels compared to the past decade. However, elevated interest in macro data will likely persist, which alongside the upcoming U.S. election, could mean more bouts of volatility through the rest of the year.
Overall, investors should view pullbacks as an opportunity to step out of cash and ensure proper diversification. Prioritizing active management, adding to alternatives — especially those that provide stable income like infrastructure — and focusing on quality companies are key strategies to manage future volatility.
Markets have mostly recovered from the recent sell-off
Source: Bloomberg, FactSet, MSCI, Russell, Standard & Poor's, J.P. Morgan Asset Management. U.S. large cap: S&P 500, U.S. small cap: Russell 2000, U.S. Value: Russell 1000 Value, U.S. Growth: Russell 1000 Growth, DM ex-U.S.: MSCI EAFE, EM: MSCI Emerging Markets, U.S. Agg: Bloomberg U.S. Aggregate, U.S. HY: Bloomberg U.S. High Yield - Corporate, Commodities: Bloomberg Commodity Index, USD: DXY Index. August correction: August 1, 2024 - August 5, 2024. Subsequent rebound: August 5, 2024 - August 12, 2024. Equity and commodity returns are price returns, bond returns are total returns. All returns shown are in USD. All data are as of August 12, 2024.