What’s behind the big stock market plunge?

The market dropped more than a thousand points on Monday, now down more than 2,650 points from the high of 41,376 seen on July 17. Much more dramatically, the Nasdaq was down 3.4 percent on Monday, and is down over 13 percent from its all-time high on July 10. Monday’s market action came after a violent 12.4 percent drop in the Nikkei (the Japanese market’s version of the S&P 500). From Federal Reserve intentions with interest rates, concerns about the economy, mixed news in this quarter’s earnings results, and general frothiness in the market, there is plenty of drama around this burst of market volatility.

Three primary issues are at the heart of Monday’s market action, and while not entirely separate from one another, they are independent enough to warrant separate coverage.

First, and perhaps most “wonky” for laymen, something called the “Yen carry trade” has unraveled in recent days. Essentially, investors borrowed the very low yielding Japanese Yen currency at high levels to help leverage riskier investment bets. As the Yen reversed over the last five days, rallying to its highest level against the dollar since the beginning of the year, those who had bet against the Yen, or who were “over-levered” in their risky investments, had to unwind these trades. This may seem complex and confusing, but at hundreds of billions of dollars of exposure, it created a ripple through markets.

Second, and more understandable, is the valuation bubble that has grown in the technology sector of U.S. stocks. Successful companies like Nvidia have dropped over 20 percent and yet still trade at 60 times their annual earnings. Many “big tech” companies have seen stock prices get ahead of themselves, and some degree of repricing has been inevitable.

Finally, a third primary contributor to market jitters has been concerns and questions about the strength of the U.S. economy. The jobs report on Friday was underwhelming, to say the least, and with a 4.3 percent unemployment rate, many who were surprised that a recession did not surface in 2023 are beginning to ask if one may surface in 2025.

Some investors believed that the Federal Reserve cutting rates would be good for markets, yet ironically the market sell-off intensified after Jerome Powell all but assured markets last week that the Fed would be cutting rates at the September FOMC meeting. There is a phenomenon at play here called “Buy the rumor, sell the news.” Since the beginning of 2023, investors have been aware of one pivotal thing—the Fed was not yet cutting rates, but was moving closer to cutting. Markets are forward-looking mechanisms and they do not wait for news to react—they price these things in ahead of them. It is very common throughout history for markets to sell off when the Fed actually begins cutting rates, when those rate cuts were highly anticipated. It is no bigger a surprise that the market would sell off when a rate cut comes than it was that the market would rally when rate cuts were not coming. The market is discounting the future, not playing catch-up with the present.

But to the third point above, we also must remember that interest rates coming lower because of economic weakness is hardly a selling point for risk assets! The market wants growing corporate profits, and corporate profits do not generally grow when the economy is weakening. Should profit expectations for 2025 be revised lower in the months ahead (because of point #3), then the high valuations of the market (point #2) offer little buffer or margin of safety. And even if the Japanese Yen issues proves to be a “one and done” occurrence (point #1), markets have now been reminded of the vulnerabilities embedded in points #2 and 3.

Very few of this can really be attributed to the political realm for the simple reason that the polls are very close, the Senate could very well go a different direction than the White House, and markets usually see through the partisan rancor of the moment. Election results may become a factor later in the year, but August is too early for that.

Ultimately, the questions in front of us have to do with whether unsustainable valuations in exciting parts if the market can be sustained longer, and whether or not economic fundamentals are, in fact, worsening. One bit of advice may be for those banking on more stretched valuations in American big tech (point #2), to learn from what those in point #1 learned … that which can’t continue, won’t.