Why reasons offered for short term stock market movement are just noise

On August 5, the BSE Sensex, India’s most popular stock market index fell by 2.7% or 2,223 points in comparison to its close on August 2. Before that, it had fallen by 1.1% on August 2.

Three major reasons were offered for this fall:

• First, the prospect of a new war in the Middle East, with Iran getting ready to attack Israel.
• Second, the prospect of an economic recession in the United States.
• Third, the unwinding of the yen-carry trade.

Now, which reason was the major reason? Or were all three reasons responsible? Or is it very difficult to pin down an exact reason for a short-term market fall?

Those who offered the reason for the prospect of a fresh war in the Middle East, had nothing to say about the wars already on between Russia and Ukraine and Israel and Hamas. Why have these wars not had an impact on the stock market? Or did they have an impact initially when they started and then stopped having an impact? Or are these wars not as big as the prospect of a war between Iran and Israel?

Now, these are not easy questions to answer, especially because people who understand the operations of the stock market may not exactly understand the economic impact of a war and vice versa.

Let’s consider the second reason—the prospect of a US recession. The US is the largest economy in the world. A US recession does have an impact on the economies of other countries as the US is the largest importer in the world. So, if demand in the US falls, its imports will come down or not grow at a good pace or even fall for that matter, leading to exports of many countries falling, thus impacting their incomes and demand negatively. Hence, it is natural for stock markets all around the world to adjust to this possibility. It is important to remember that stock markets do not wait for events to happen, they discount for possibilities.

Nonetheless, people who offered this reason did not bother to explain why the prospect of a US recession became so obvious as soon as the month of August started and which egged more investors to sell than buy, leading to the stock markets all across the world falling.

Also, the BSE Sensex and other stock market indices around the world have rallied post-August 5. What’s the explanation for that? Has the prospect of a US recession become less? Or have more investors been buying on dips as stock prices fell? And are these investors not taking the prospect of a US recession or a war in the Middle East into account? Or is the classic dead-cat bounce at work, where even during falling markets, stock prices can go up now and then?

Now, that leaves us with the yen carry trade. Many newbie retail investors have come to realise that something happening in Japan can have an impact across other parts of the world. That’s the butterfly effect.

So, what exactly is the yen carry trade? Interest rates in Japan have been at very low levels. This has led to many investors borrowing money in Japan in yen and investing it in financial assets across other parts of the world, where their chances of earning a higher return are better. The difference in the return they make by investing across the world by borrowing in yen and the interest they pay on borrowing in yen, is referred to as the “carry,” and from this comes the term yen-carry trade.

For yen carry trade to be viable, two things are necessary. First, interest rates in Japan need to be stable or go lower from where they are. Second, the yen needs to either remain stable against the US dollar or depreciate against it. The moment any of these conditions is broken, the yen-carry trade starts to become unviable and investors start selling their investments and repaying the money they had borrowed in yen.

Now, the Bank of Japan, the Japanese central bank, recently raised interest rates. This made borrowing in yen more expensive thus making one part of the yen carry trade unviable. Other than that, the yen has also been appreciating against the dollar. Let’s try and understand this through an example.

Let’s say one dollar is worth 160 yen. At this point, an investor decides to borrow 160 million yen. This is converted to dollars and the investor gets $1 million which is invested. For ease of understanding, we will not consider any currency conversion costs.

Sometime later a 5% return has been earned on this investment and it now amounts to $1.05 million. Meanwhile, the yen has depreciated to 164.5 to a dollar. So, when the $1.05 million is converted to yen, the investor gets around 172.7 million yen. The initial investment was 160 million yen. This implies a return of around 8%. Let’s say an interest of 1% is paid on the borrowing of 160 million yen, so, the net return works out to 7%.

Now, let’s say the yen instead of depreciating had appreciated and one dollar was worth 152.4 yen. When the investor converted the $1.05 million to yen, they would have got 160 million yen. This was the original amount invested. So, there are no returns made on the investment. Further, let’s say interest rates have gone up to 2%. This implies a net loss of 2% for the investor.

This shows how higher interest rates in Japan and an appreciating yen knock out the yen-carry trade. With the yen appreciating over the last month and interest rates in Japan going up, the unwinding of the yen carry trade looks like a good reason for the stock markets falling. The trouble is we don’t have a detailed breakdown of this kind of data available in the public domain. What’s the kind of money that has been borrowed in yen and invested in let’s say the Indian stock market? Also, the yen has depreciated during the day today (August 7) though it has been largely appreciating against the dollar since July 10. Has it changed direction? Will the Bank of Japan not raise interest rates any further?

Now, these are not easy questions to answer. There are too many factors involved making it a very complex situation.

Given this, it’s very difficult to explain the short-term movements in a stock market. Of course, not for once am I suggesting that stock prices did not fall because of these reasons and that there were other reasons at play. But there is no way of figuring out whether the prices fell just because of these reasons or they fell because once they started falling a little many investors simply sold out because the prices were falling. Individual investors make their decisions and it’s very difficult to figure out those reasons in the aggregate.

Given this, the reasons offered for the movement of a stock market in the short-term are basically noise. And it makes more sense for investors to stay away from this noise.