Markets meltdown: 5 reasons why stocks crashed in ‘perfect storm’ of AI, rate hikes and jobs fears

Japanese equities fell by more than 12 per cent, with market analysts citing a “perfect storm” of circumstances leading to dramatic declines.

The results, felt first in Japan’s Nikkei 225 share index, which was down more than 12 per cent by the end of the day, will reverberate around the global economy.

Global market meltdown

The losses in Tokyo were the biggest since the notorious “Black Monday” in October 1987.

Peter Garnry, Chief Investment Strategist at Saxo Bank, said: “Financial markets were already shaky on Friday with the weak US jobs report triggering discussions about that the Fed had made a mistake by keeping interest rates too high for too long.

“Today the worries that surfaced on Friday exploded into significant risk reduction and a historic move in Japanese equities down 12 per cent.

“This is the biggest single day decline in Japanese equities going back as far as 1959. Equity futures are also pointing to a significant down day in US technology stocks indicated down 3.9 per cent in pre-market trading”.

Garnry identified a perfect storm of five key factors behind the falls. A combination of economic principles, surprise rate increases and market concentration are partly to blame for the massive losses and market instability.

Furthermore, AI investors drawing profits following bull run in markets are contributing to the declines.

Saxo Bank identifies 5 factors in perfect storm market turmoil

• Sahm rule: Recession fear as the “Sahm Rule” is triggered. The “Sahm Rule” is triggered when the three-month average US unemployment rate is up more than 0.5 per cent from its low over the previous 12 months. This indicator has correctly identified every recession since WWII, so its triggering on Friday planted the seeds of recession fear that led to declines in equities
• AI profits: AI profit-taking after massive bull market. The AI and semiconductor theme had been one of the strongest themes over the past year. When there is a turnaround in sentiment the pockets with the most momentum are always hit the most
• Japanese rate hikes: Surprise JPY rate hike upsetting funding markets. The Japanese central bank has kept its policy rate much lower than any other central bank throughout this entire cycle causing the JPY to consistently decline. As a result, JPY has been a key funding current for leverage in financial markets. The central bank’s surprise decision to hike the policy rate last week while making hawkish comments have caused turmoil in JPY and funding markets
• Divergence trades: One-day options and the “divergence trade”. The US options market has become enormous and especially the one-day options market has become a dominant force. In addition, Wall Street has been playing an options game called “divergence trade” which involved selling VIX futures and buying call options on technology stocks. When the VIX Index explodes higher this trade has to be unwound quickly. It adds to the volatility and increases market moves
• Equity market concentration: Saxo Bank has written a lot about historical equity market concentration. In late June, the US equity market reached its highest market concentration since the 1930s meaning that the equity market weighting is dominated by a small group of stocks. This increases the risk in the equity market because the diversification is lower and thus more fragile to a change in sentiment as we have seen today

Despite the dramatic activity in global markets, Saxo Bank is advising long-term investors to remain calm.

It highlighted the VIX Index (the fear index) fell to 38 from 18 in just two trading days.

This indicator of market volatility led to investors looking to sell off stock quickly and Saxo says markets will be active and fluctuate rapidly.

Peter Garnry said: “This is exactly why long-term investors should avoid reacting too much today. As Warren Buffett has famously said ‘The stock market is a device which transfers money from the impatient to the patient’.

“The worst mistake any investor can make today is drastically selling positions.

“The correction in US equities is set to reach around 7 per cent today from the peak in July based on equity futures in pre-market.

“This is what is called a mild drawdown and something that is seen rather often inside a longer bull market and a positive economic cycle.

“If the next round of macro indicators worsen then the decline could extend to around 15 per cent which would take the S&P 500 Index down to around the 4,800 level.

“The 5,000 level in S&P 500 was where the market bottomed back in April and where the 200-day moving average is currently sitting. A 15 per cent correction is more rare but typically an important inflection point because either the recession is not coming and equities rebound, or the recession is coming and the correction extend further.