THE NEW YORK TIMES: How to cope when the financial markets are in freefall

Time can speed up radically in the markets. It accelerated to supersonic speed over the past week, and you could have gotten whiplash if you tried to keep up with it all.

Global stock and bond markets rose and fell and rose again in cascading waves, moving across oceans and time zones. Fears of a recession in the United States mounted, and the Federal Reserve came under pressure to cut interest rates and spur growth.

Panic can happen easily in market declines, and it can vanish just as quickly. Late in the week, it was almost as if the seemingly calamitous market whirlwind had never happened.

The episode provided a reminder of why, when your own money is at stake, it’s so important to pause, take a deep breath and think calmly. What we just experienced wasn’t all that severe, on a historical basis, at least not in the United States — but it could well presage deeper losses down the road. Big downturns are part of investing, much as recessions are part of economic life.

Don’t act hastily when the markets are turbulent. But when things are reasonably calm and you can think and act deliberately, remember that most of the time, broad diversification helps reduce risk. As I pointed out in a column written shortly before stock markets fell and bonds rose in value, it’s worthwhile to rebalance your portfolio periodically, making sure you still have a mixture of stocks and bonds that isn’t riskier than you can handle.

It started in Japan

Tokyo was the epicentre of the market action. The benchmark Nikkei 225 stock index fell 12.4 per cent Monday, its biggest one-day decline since 1987. But this debacle was followed the next day with a boisterous rebound of more than 10 per cent. Behind the stock market volatility were big shifts in the value of the yen, and small ones in interest rates.

The yen had been weakening for weeks — making oil and other commodities costly for Japan, which depends heavily on those imports — so the Bank of Japan raised interest rates for the second time in 17 years on July 31. That had the desired effect of bolstering the yen, but it made a classic financial maneuver, known as a “carry trade,” far less attractive.

In such a trade, you borrow at low rates in a cheap currency like the yen and invest in a market that promises better returns, like the U.S. stock market. For years, Japanese rates had been stuck at or below zero, making it an ideal borrowing spot. By disrupting that trade, the Bank of Japan’s sensible shift in interest rates contributed to the sudden weakness of what had been a booming Japanese stock market — and to the disorder in other world markets.

By comparison, the U.S. stock market was sedate. The S&P 500’s mere 3 per cent downturn Monday was a faint echo of the harrowing fall in Tokyo, but it was more than enough to command attention. Even at just 3 per cent, it was the biggest one-day decline since September 2022. And while the U.S. market mirrored Japan’s and rebounded Tuesday, its bounce was comparatively small, a gain of 1 per cent. But it was enough to end the immediate panic.

Even though the sell-off was fairly minor in the United States, there were alarming headlines and hints of real trouble in the markets. This fierce reaction occurred, I think, because the U.S. markets had been lulled into complacency by the calm conditions that had largely prevailed since stocks bottomed in October 2023.

Consider the remarkable dance of the Vix index. Formally, its name is the CBOE Volatility Index, but it is often called Wall Street’s “fear index” because it tracks options on the S&P 500 that rise in price with market stress.

On Monday morning, the Vix soared to screamingly high levels, only to flutter down by lunchtime to a level associated with run-of-the-mill market agita. Its extraordinarily brief rise and fall amounted to the fear index’s greatest one-day round trip since its introduction in 1993, according to researchers at the independent Bespoke Investment Group.

In short, the data suggests that U.S. professional traders were caught up in an outright panic as the market declines in Japan spread to Europe and then to New York on Monday — but they pulled themselves together quickly.

Investors may not be so fortunate next time.

Bonds respond

One saving grace amid the stock market tumult was the performance of bonds. Fixed-income markets have not received much attention lately, but they have delivered excellent news.

Unlike in 2022, when stocks and bonds fell simultaneously and investors found few places to hide, bond gains in recent days partly offset stock losses.

While the S&P 500 fell 6.1 per cvent in August through Monday in the worst of the downturn, an index tracking long-term U.S. Treasury bonds leapt more than 4 per cent.

If you held high-quality bonds through this stretch, and were well diversified in your overall portfolio, the overall market action was probably not too painful.

In 2022, as inflation rose, so did interest rates, hurting bond returns (when rates or yields rise, bond prices fall, as a matter of bond math).

Now, with inflation abating and unemployment beginning to rise, bond yields have been dropping, perhaps in anticipation of an economic slowdown — and of interest rate cuts by the Federal Reserve.

Yes, a recession is coming

The timing of the next recession is an issue that has confounded market strategists and economists for the last couple of years. Typically stocks are pounded in recessions, while investment-grade bonds, and particularly U.S. Treasurys, flourish because interest rates are most likely to fall in these periods, bolstering bond prices.

A weak jobs report Aug. 2 revived dormant worries about a possible recession and raised expectations that the Federal Reserve would cut rates at policymakers’ next scheduled meeting in September. There even were bets that the Fed would rescue the markets in an emergency session.

The market-based probability of a half-percentage-point rate cut by September leaped to 70 per cent by Aug. 7, from 5 per cent in early July. And traders expect that by the end of the year the federal funds rate will drop at least 1 full percentage point from the current range of 5.25 per cent to 5.5 per cent. These expectations put pressure on the Fed to act. Otherwise, the markets could resume their painful downward gyrations.

I’d simply say that one thing is clear: A recession is coming. You can count on it.

But don’t be alarmed. I don’t know when it’s coming — nor do any of the people who have been trying to predict a recession over the last couple of years.

Part of life

While the concept of a recession is emotionally charged because recessions typically bring pain for millions of people, recessions are far more commonplace than is widely understood.

People in the markets constantly try to put numerical probabilities on the arrival of a recession in the next year, despite their inability to do so reliably. Several tried this past week. Goldman Sachs garnered headlines when it raised the odds of a recession in the next 12 months to 25 per cent, from 15 per cent — which was described as a large probability. I’d say it’s meaningless.

In June 2022, in another moment of heightened recession fears, I calculated that the United States had been in a recession 14% of the time from 1945 through April 2020. That number isn’t a wild guess. Its history, based on the recession dates set by the National Bureau of Economic Research, is the closest entity the United States has to a true authority on recessions.

What’s more, on any day in the postwar period, the chance that the United States was in a recession, or would be within two years, was 46 per cent. That conclusion was based on simple math provided by Salil Mehta, an independent statistician, using the bureau’s data.

I looked at the data on recessions again this past week and did some fresh calculations, which Mehta verified for me: The chance of a recession within 12 months on any day in postwar America has been 30 per cent.

In short, history suggests there is always a sizable chance that a recession is coming fairly soon. Don’t worry about it. Prepare for it.

Similarly, stock market declines much bigger than the one we just experienced are commonplace. The S&P 500 falls at least 10 per cent at some point each year on average. That hasn’t happened lately, but don’t be shocked if it does, especially in a volatile election year.

Over the long run, stocks have produced great returns, but the trick is staying in the market long enough to benefit. So, diversify and rebalance. If it will help you sleep better, hold more investment-grade bonds. The recent turmoil is a reminder of why all of that is so essential.

This article originally appeared in The New York Times.

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