The Stock Sell-off is Grounded in One Labor Market Indicator

The hope that the strong sell-off in global stock markets has at least temporarily halted faded on Tuesday. After the Japanese Nikkei index rose by eight percent, partially healing the wounds from the largest daily drop in the last 37 years of 12 percent, European exchanges also opened trading in the ‘green’. However, by noon, the German, French, Italian, and British stock indices began to lose value again, between 0.3 and 0.8 percent. The European STOXX 600 also recorded a decline of 0.3 percent.

The situation across the Atlantic is no better. Futures contracts on all three major American stock indices, Dow Jones, S&P 500, and Nasdaq, suggested that stock Tuesday could bring a significant recovery, above one percent. However, as European indices lost value, the growth of futures contracts, which were mostly in the plus between 0.2 and 0.3 percent by noon, also melted away.

The main drivers, but also weights

The summary of the three-day sharp sell-off on Wall Street, concluding on Monday, sounds like this: all three stock indices recorded the largest drop in three days since June 2022. Moreover, the Nasdaq and S&P 500 stopped at their lowest levels since early May. Thus, the technology index plummeted to 16,200 points, and the measure of the 500 largest companies to 5,186 points. The level of uncertainty in the market is indicated by the fact that the VIX, known as the ‘fear index’, stopped at 33.51 points, the highest level since the end of the pandemic in October 2020.

The main drivers of the rise in the American market are now also the largest weights. This refers, of course, to the ‘Magnificent Seven’ stocks of large technology companies. Just on Monday, Microsoft and Meta fell by three percent, Apple, Tesla, Alphabet, and Amazon lost four percent in value, while the biggest blow was suffered by Nvidia, whose stock price was cut by an additional seven percent. In total, the ‘Magnificent Seven’ lost 800 billion dollars in market value on Monday.

However, even such a strong three-day sell-off did not manage to push these stocks into the negative when looking at their price from the beginning of the year. Namely, Nvidia is still worth almost twice as much as at the beginning of 2024, Meta more than 34 percent, and Alphabet 14 percent. Apple is up seven percent, and Microsoft and Amazon five percent each. Only Tesla records a decline, and that is a significant 21 percent. In addition, the entire Nasdaq, which is nominally in the correction zone (having lost more than 10 percent compared to its record value), still records a six percent increase for this year, and the S&P 500 nearly nine percent.

In other words, the three-day price plunge has not managed to significantly ‘cool down’ the valuations of American stock indices, which a good portion of analysts claim are quite stretched due to the strong and rapid rise in stock prices this year. For example, the price-to-earnings ratio for stocks in the S&P 500 is still around 20, compared to a long-term average of 15.7.

The dawn of a recession?

Although such a sell-off is a logical outcome after the frenetic rise we have witnessed in recent months, analysts always offer some excuse. So far, two main theories have crystallized as to the reason for the stock market decline. The first is that it is about cashing in profits by large funds that financed stock purchases by borrowing in Japanese yen. This is a long-standing strategy of taking loans in the currency of a country with lower interest rates, such as Japan or Switzerland, and after that currency is converted into dollars, investing in assets that offer higher returns, such as stocks. According to analysts, this speculation has become less profitable after the Japanese central bank raised interest rates in July.

This reason should have a short-term effect on the current negative sentiment, so it is worth taking a closer look at the second reason. This is concern for the state of the American economy, which, according to some, is getting closer to recession. The main trigger for such thinking was last week’s release of statistics on new jobs, which showed that only 114,000 new jobs were created in July. This result is quite disappointing considering that an average of 170,000 jobs were created in the last three months, and in the first quarter, American employers hired as many as 267,000 new workers per month.

Accordingly, the unemployment rate in the U.S. has risen for the fourth consecutive month, to 4.3 percent. This is the highest unemployment rate since October 2021 and is nearly a full percentage point higher than the lowest level recorded in January last year. Therefore, many refer to the so-called ‘Sahm Rule’, named after economist Claudia Sahm, who demonstrated a causal link between rising unemployment and falling economic activity, or the onset of recession. The rule states that a recession occurs if the three-month moving average of the unemployment rate rises by half a percentage point compared to the lowest value in the last year. The Sahm Rule has never been wrong in signaling a recession.

The worst possible decision

As for other indicators, there is still no talk of a recession in the U.S. In the second quarter, U.S. GDP grew by 2.8 percent, double that of the first three months. Moreover, such quarterly growth corresponds to the average economic growth recorded in the U.S. in the three years before the pandemic. A more precise indicator of economic activity that the Federal Reserve closely monitors – growth in personal consumption – remained at 2.6 percent in the second quarter. The same applies to the state of the service sector, which accounts for two-thirds of American economic activity. The S&P service sector index in July was close to its highest level in the last two years.

Whatever the reason, this is neither the first nor certainly the last significant drop in stock prices. Moreover, stock market history shows that in such cases, it is merely the announcement of the beginning of a new episode of growth. Namely, in the last 44 years, the Nasdaq index has entered correction 24 times, or on average every two years, according to Reuters’ analysis of LSEG data. In two-thirds of cases, the index reached a higher level just one month after the correction occurred.

Despite this, it is difficult for small investors to remain calm in such situations, and a good portion of them decides on a move that often later proves to be wrong – selling stocks.