Slow Boat to China
Due to the November general election, the next couple of months are going to be contentious and
uncertain. The uncertainty may cause corporate America to delay making material decisions since
the two major political parties have stark differences in handling matters. After the election, some
clarity may be shed on many of the important variables business leaders need to know before
formulating plans. A couple of key items include:
- Who is the President, and which party controls the Senate, and the House of
Representatives - Taxation
- Handling of deficits and interest rates
- Who oversees the Federal Trade Commission and the Justice Department
Each of these items has far reaching consequences for business and rampant speculation spreads
as the polls gyrate. During periods like this I recommend having an investment perspective of
being on a Slow Boat to China and not being able to change things too easily. Many investors get
hurt by reacting to headline news without understanding how fast the market reflects news.
In my last review I discussed the disparity in the total value of large stocks measured by the S&P
500 over small stocks measured by the Russell 2000 Index. It included a graph which indicated
the spread was over 2-standard deviations away from the average which means that greater than
95% of the time, such a disparity does not exist. As suspected, there was an adjustment in values
with the smaller company Russell 2000 index, gaining in value much more than the increase in
large stock values. Barring a recession, small-cap stocks may continue their outperformance as
many large stocks remain richly priced.
During the third quarter of 2024, the S&P 500 Index gained 5.5%, the NASDAQ Index gained
2.6%, the Russell 2000 Growth Index gained 8.3%, and the iShares Barclays 7-10 yr. Treasury
Bond ETF (IEF) gained 4.8%.11
When formulating an investment path, I look at many variables other than the disparity of asset
pricing. One key item is interest rates.
Interest rates affect:
- The value of a country’s currency
- Stock prices, since future earnings are discounted accordingly
- The cost and magnitude of borrowing
- A business’s calculations about future profitability
Early in the quarter the S&P 500 index experienced a peak to trough correction of nearly 9% in a
few weeks. A contributor for the selling came from institutions unwinding the Yen Carry-Trade
(carry-trade). With a carry-trade, an investor borrows in the currency of a country with low interest
rates, like Japan, and puts the money in other assets such as U.S. Treasuries, stocks, and other
currencies in hopes of higher returns. This strategy turned sour, quickly, when the BOJ hiked rates.
In late July, the Bank of Japan (BOJ) raised their interest rate from 0.00-0.1% to .25%, the highest level since the global financial crisis in late 2008. A quarter of one percent may seem negligible, but for institutions, it significantly raises borrowing repayment costs—often substantially.
Straight carry trades usually offer modest returns but leveraging them—even at five to ten times—can amplify those returns dramatically in markets where leverage is as high as 200:1. The downside? Paying back a losing 200:1 leverage position is excruciating.
In Safe Haven Currency countries, such as the U.S., Japan, Switzerland, and Britain to name a few,
when their interest rate goes up, so does that value of their currency since interest rate returns are
more attractive on a relative basis.
Japan’s surprise interest rate increase meant that the borrowers were now having to deleverage and
unwind their losing carry-trade positions with more expensive Japanese Yen. Selling at a loss
compounds the issue, as more and more assets must be sold to cover the shortfall. Soon after the
panic selling erupted, the BOJ scaled back their rhetoric to increase interest rates which seemingly
stopped the financial bleeding and stock market rout.
My belief is that the carry-trade continues to be a worry since it may not have gone away and there
could be a risk of renewed selling. Depending on the speed and magnitude of another possible
rout, it may be an opportunity for stock investors.
In the U.S., a key driver of interest rates stems from the Federal Reserve (Fed) striving to
accomplish their dual mandate of low and stable inflation, (around 2%), and maximum
employment. Recently, the Fed seemingly has changed its focus from taming inflation to maximum
employment and in September, lowered interest rates. Lower interest rates generally spur
economic activity.
In October, the September Non-Farm Payrolls release purported that 254,000 jobs were created,
far exceeding the expected 150,000. I question the reliability of this surprisingly high figure,
especially given its release so close to a contested election. Historically, these reports are often
subject to revision.
The United States Bureau of Labor Statistics (BLS) puts together the nonfarm payroll data
collected from the surveys. Even though it is government data, there are at least two material
problems that exist. The first is that the data collected is self-reported by businesses and
individuals, both of which are subject to error. The second is that the BLS makes subjective
seasonal adjustments to the payroll number.
As evidence to my suspicion, on Aug 21, 2024, the BLS reported that the U.S. economy created
818,000 fewer jobs than originally reported in the 12-month period through March 2024. They
also stated that the actual job growth was nearly 30% less than the initially reported 2.9 million
from April 2023 through March of this year.
The unusual payroll report leaves the Fed and investors in a difficult interest rate dilemma. The
markets are interpreting the Fed’s interest rate expectations for further lowering this year and
further cuts in 2025. Lower interest rates are generally good for the economy and stock prices, but
how can the Fed lower rates if payrolls are growing much faster than expected. If the Fed lowers
rates in alignment with expectations, they risk renewing higher inflation which hurts consumers
and businesses. If the Fed doesn’t lower, or even raises rates, to offset higher than expected payroll
growth, stock prices will likely drop and on a relative basis, the Japanese Yen will become stronger
which will aggravate the carry trade situation once more.
The development of interest rate trends and implications is dynamic and must be followed closely.
Unfortunately, no one has a crystal ball and hard work must constantly be applied.
As we go through the election season and quarter, I again recommend for myself and investors to
have a Slow Boat to China perspective and not jump at every headline as the media sells news, not
vetted investment advice.
As always, I will be vigilant in following and assessing new developments to take advantage of
new ideas and minimize risks as I see them.
Very truly yours,
Martin L. Yokosawa
Torii® Asset Management, Inc. Landolt Securities, Inc.
9S040 Stearman Drive, Naperville, IL. 60564 (630) 420-0221
Copyright Martin L. Yokosawa. All Rights Reserved
Securities processed by and investment advice provided through Landolt Securities, Inc. Member: FINRA/SIPC
Torii Asset Management, Inc. and Landolt Securities, Inc. are not affiliated companies.
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contained in this quarterly review is intended to be, nor shall it be construed as, investment advice
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- These returns are price based and exclusive of dividend reinvestment. Return data provided by QUODD Financial,
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