Market Turmoil: Why Is Liquidity Drying Up?

Hey guys, Brian here. I hope your week’s going great.

The markets have obviously been wild this week. I’m recording this on Thursday morning, August 8.

The press really loves to latch onto storylines when markets get volatile. Three big ones have popped up. I’ll talk about in this video: the yen carry trade, the Sahm Rule Indicator, and Berkshire Hathaway’s cash position.

To spoil the punchline here — none of these things are actually causing the sell off. But I think they are important for other reasons.

Stay with me.

Alright guys, welcome back. First up, the yen carry trade.

Traders borrow in Japanese yen. They convert the yen to dollars. They invest those dollars in higher yielding assets. Carry trades are nothing new.

This one had been especially popular because (1) it costs virtually nothing to borrow yen; (2) the dollar had been strong, so there was no problem reconverting and paying back the loans; (3) higher yielding investments have been everywhere.

The money from this trade has made its way into bonds and stocks, and primarily a handful of tech stocks. All of this has begun to unwind now. Rates have been slowly rising in Japan. The yen suddenly rallied against the dollar. I’ll put up a chart here illustrating the huge move in forex last week. And the tech darlings have hopped, right? This chart of the Magnificent Seven shows what could very well be a long-term peak.

Many people say that yen carry is causing the equity selloff. I get the reasoning. It created all this liquidity. It pushed stocks higher. Now that liquidity is drying up, forcing stocks lower. I get the argument.

It misses the point, though, because the foundation for liquidity is optimism and confidence. The source of that liquidity is kind of immaterial. It could be yen carry, it could be QE. Regardless of the source, the liquidity spigot gets turned off only when optimism and confidence go away.

That’s what’s happening now and, not to add to the fear mongering here, but this really has all the vibes of Long-Term Capital Management in the late ’90s. If you’re young, read up on LTCM. It would not be surprising at all if a major investment house or two or three is trapped underwater right now.

Now, speaking of liquidity, Berkshire’s cash position. This one’s been all over the press. Second quarter filings show Berkshire basically sold half its position in Apple and piled into treasuries. Now, Buffett obviously invests on the fundamentals. It clearly works for him.

As a market technician and as a wave analyst, I think this pattern in Berkshire’s cash position is very compelling. For one, just the sheer volume of cash confirms that the best value investor in the world cannot find any value. That’s very much aligned with our own thinking.

The more important part of this graph is what it suggests about coming equity values. This is a fairly classic five-wave advance. So, the next draw down should be the largest of the entire pattern. That’s larger than Wave 2, larger than Wave 4. Those buying sprees took place during the ’08 meltdown and following the 2020 crash.

So now, let’s just say this cash position comes back inside the trend channel. That alone is a couple hundred billion [dollars]. If we got back to the previous fourth wave low, that’s a buying spree of nearly $300 billion.

So, our view is that equity prices need to come down a lot before Berkshire goes shopping for stocks on that kind of scale. So let’s see what happens.

Now, last thing to mention is the Sahm Rule Recession Indicator. It got triggered with the jobs report in early August. This one’s been all over the press. Claudia Sahm, American economist. She discovered a link between recessions and changes — specific changes — in the unemployment rate and introduced the idea in 2019. But it has been back tested.

You’ve likely seen this graph in the press. It has signaled the start of every recession since the 1970s. I think this is super interesting. Sahm found a pattern in the data that appears to be a useful signal.

One thing to realize, however, is that the Rule has not been predictive. It has signaled recessions when they were already beginning. The other problematic narrative is that this triggering of the Sahm Rule has caused stocks to sell off.

Completely disagree here. Investors didn’t wake up in August and say, “Oh, Sahm Rule’s triggered. Better sell stocks.” Investors were quietly selling this market long before the Sahm Rule was triggered. Dow Transports for example, peaked back in 2021. Utilities peaked in 2022. Even the Industrials and the S&P and the NASDAQ, those indexes peaked in mid-July, which was before the Sahm Rule got triggered.

The way we would describe things is that optimism has been receding. That negative mood trend was first reflected in stocks. Now it’s showing up in economic data. If it persists, the economy will eventually contract, and that contraction could be quite large, depending on the size of the bear market. That is the socionomic take.

Let me know what you think in the comments. Thanks for watching. and I will see you in the next video.