Market Turbulence Creates Opportunity

By Thomas Hartmann-Boyce, CFA, Grant Banko

Client Portfolio Manager

Thomas Hartmann-Boyce joined ARK in June 2021. As Client Portfolio Manager, Thomas works directly with ARK’s investment team to communicate in-depth knowledge of investment-level detail to internal and external clients.

Client Portfolio Specialist

Grant Banko joined ARK in March 2024. As Client Portfolio Specialist, Grant works directly with ARK’s investment team to create and deliver in-depth knowledge to internal and external clients. Prior to ARK, Grant was a Client Portfolio Manager at AllianceBernstein where he served as a specialist on the Concentrated Growth Equity and Select US Equity Platforms. Prior to joining AllianceBernstein in 2022, Grant held various business development roles at Franklin Templeton Investments over the span of five years, the majority of his time spent as a specialist for the Templeton Global Equity Group. Grant holds a Master of Business Administration from University of Florida and Bachelor of Science in Computer Science from Eckerd College.

We understand that current market conditions are challenging. To assist investors in navigating this volatile market environment, we leverage ARK’s 40 years of experience investing through multiple market cycles to offer our views.

Executive Summary

The market has shown signs of extreme turbulence due to the perceived combination of: 

• The unwinding of the decade-long yen carry trade¹
• A US economy whose cracks have now become visible fractures
• A hesitant US Federal Reserve (Fed) that has been slow to cut rates, despite multiple warnings

Importantly, the megacap tech names that steer common benchmarks have shown genuine vulnerability. In the last week, as US statistics like employment and the Purchasing Managers’ Index (PMI) have disappointed expectations and, at the same time, the Bank of Japan has raised interest rates more than expected, investors and speculators may have faced margin calls² forcing them to unwind the yen carry trade.

It appears that significant capital from the yen carry trade was used to pile into mega-cap stocks, which may now be experiencing a correction in light of macro developments. We encourage investors to reassess portfolio concentration risk and consider ways to diversify exposure.

While these types of selloff are sparked by market fear and risks to consensus positions, they often create pockets of opportunity. Historically, condensed bouts of volatility have led to a market rotation that can favor a broadening out from the contributors to volatility. In our view, although disruptive innovation may be susceptible to volatility in the current climate, given its relatively high beta³ and the unknown length of the market shock, it also may benefit from a more receptive Fed, a general broadening out away from the prior consensus, and clarity regarding the shift of inflation to disinflation.

Recent Drivers Of Market Turbulence

Three developments may be driving widespread market turbulence experienced in August.

Unwinding of a Decade Longer Carry Trade: BoJ Rate Hikes 

Over the last decade, some investors have benefited from using Japan’s low (or even negative) interest rate environment to execute a “carry trade”—that is, to borrow (or “short”) Japanese yen or government bonds in favor of reinvesting that capital in other areas with higher yield and/or potential reward, such as US Treasuries.

According to industry estimates, as much as USD $20 Trillion may have been directly or indirectly allocated to this carry trade, which is roughly 15% of the global equity market capitalization.⁴

On July 31, The Bank of Japan (BoJ) raised its key interest rate to about 0.25%, from a range of zero to 0.1%, perhaps to curb the yen’s depreciation against the US. Dollar. The central bank also noted that it would reduce the monthly bond-buying to JPY 3 trillion in January-March 2026, from the current pace of around JPY 6 trillion, to pursue a more normal monetary policy.

While the U.S. Federal Reserve (The Fed) kept rates unchanged in July, market participants appear to have begun unwinding that carry trade, perhaps out of necessity (i.e., margin calls). 

As a result, the markets reverberated violently, and it appears that unsuspected areas of the financial markets, namely broad indices highly concentrated into the “Magnificent 6,”⁵ may have been buoyed by that leverage, creating a liquidity spiral as forced sellers unwound the carry trade. Perhaps investors wanted an additional boost to yield beyond assets such as U.S. Treasuries by purchasing mega-cap stocks that had high cash balances, dividend issuance, and the added boost of technological tailwinds.

As we have highlighted this year, the interconnectedness of the Magnificent 6’s revenue and earnings—and the concentration into those names due to the popularity of market capitalization-weighted indices—can lead to outsized risk in client portfolios. We believe that the dynamic warrants examination, and the current unwinding of the carry trade provides a new case in point.

Japan’s stock market saw its worst single-day crash since 1987 on August 5th, and the Magnificent 7 stocks erased close to $1 trillion in market cap in a single day.⁶ The market now is trying to understand how much debt still needs to be unwound and who could be left holding the bag. 

Slowly and Then All at Once: Weakening of the US Economy Can No Longer Be Ignored

Exacerbating markets, cracks in the US economy became increasingly visible as last week’s PMI and employment numbers underscored weakness: US ISM (Institute for Supply Management) Manufacturing PMI decreased -3.5% month-over-month as the US unemployment rate climbed 0.2% month-over-month to 4.3% in July.

We believe that the US economy has been tiptoeing through rolling recessions,⁷ as exemplified by weakness in commercial real estate, now bleeding through to multi-family, a stall in auto sales to sub-normal expansion rates, a fall in capital spending, and a relapse of consumer confidence. However, we think the Fed has been too focused on inflation for too long, perhaps missing other, more important economic problems. Those looking beyond core inflation figures would have seen that prices have come down dramatically across wholesalers and retailers. ARK’s concerns about potential disinflation appear to be coming to fruition.

Now, the weakness in these leading indicators is being felt in lagging indicators that even the Fed cannot ignore, and the market seems to be reassessing how hard a landing we could be in for, even if the Fed eventually shifts its mindset in response. Indeed, we have seen a massive shift in consensus views.

The Fed Has Been Slow to React: Lack of July Cuts

Importantly, the Fed isn’t just late to the rescue; it hasn’t even responded to the call. Market turbulence is showing how dire the economy may be and how any procrastination in rate cuts can be detrimental.

The market was widely expecting rate cuts to begin in September, but this market shock has triggered calls for more timely rate cuts. In fact, after Friday’s unemployment data were released, Economist Jeremy Siegel stated that the Fed should make an emergency cut of 0.75% ahead of another 75 basis point cut in September. The market agrees—it is pricing in a 60% chance of an emergency Fed cut as of August 5th.⁸

The question is, will forthcoming rate cuts, whether on an emergency basis or not, be too little too late? Can they be the remedy for which the markets have been waiting? One thing is for certain: this bout of uncertainty has underscored risks to the latest consensus bets, and clients are reassessing their exposures in light of updated short- and medium-term market outlooks.

Market Shocks Often Create Investment Opportunities

Current market turbulence has underscored a more abrupt economic slowdown than many anticipated, shedding light on the lack of diversification in investor portfolios, and may have created an important investment opportunity for a market rotation. We begin by comparing the impact of this market shock to those of other historical events, examining how prior shocks have created buying opportunities. Finally, we discuss why the recent market shock has the potential to benefit disruptive innovation.

Historical Comparison of Periods with Condensed Volatility

The recent market shock has been one of the most volatile events in recent history. The VIX⁹ Equity Volatility Index shot up to 65 on August 5th, the fourth-highest level in the past 40 years: “portfolio insurance” failed on Black Monday in October 1987; Lehman Brothers went under in 2008; and COVID hit in 2020. What does the current situation mean in relation to prior events? Using history as a guide, other cases of condensed, short-term volatility created investment opportunities:

• In 1987 and 2020, the panic/cathartic moves in the VIX created significant buying opportunities, particularly for stocks trounced during those downturns.

• In our view, the spike in the VIX on August 5th stems from conditions resembling both 1987 and 2008. On Black Monday, in 1987, portfolio insurance failed, because those relying on it tried to cash out at the same time—much like those relying on the carry trade with Japan today. Delivering consistent returns over many years, the yen carry trade probably was leveraged and is hurting macro-oriented strategies disproportionately today. Like 1987 and unlike 2008, its impact could be limited.

• In 2008, however, after the VIX spiked, the broad-based equity markets waited another six months to bottom, in March 2009. The volatility surrounding the Global Financial Crisis of 2008/2009 likely was warranted by the vast amount of leveraged debt held by systematically important financial institutions. Assessing risk globally was painful and resulted in the great recession, putting enormous pressure on the financial sector. That said, it created an incredible buying opportunity months later, ultimately leading to a longstanding bull market, especially for technology and innovation-oriented companies.

• When the COVID pandemic practically shuttered the world in March 2020, it created a short but profound buying opportunity during the rapid V-shaped economy.¹⁰ Innovation stepped in to solve many problems, leading to propelled performance in the stock markets.

The unwinding of the current carry trade is still in discovery process, though markets demonstrated resilience in the second half of the trading day on August 5th and on August 6th. Market participants seem to be unsure what has or will be broken, where the potential “whales” reside, or who will be exposed. Some estimates suggest that 50-60% of the unwinding may have occurred on August 5th, and others suggest that this could play out over a longer time frame.¹¹ One thing is for certain: investors are watching the markets closely and analyzing their clients’ exposures.

Often these market shocks accelerate a rotation away from the names that contributed to the turbulence. In this case, investors may be reassessing their risk appetite for the “Magnificent 6” and may decide to diversify their portfolios in an effort to manage risk and to participate in a broader opportunity that may have begun in July. 

Disruptive Innovation Has the Potential to Benefit

In our view, disruptive innovation will be susceptible to volatility in this climate, given its relatively high beta, but it also may benefit from the shift from inflation to disinflation, technological tailwinds, as well as a more receptive Fed.

Today, pricing is coming down across the world as corporate margins face pressure. That’s an example of “bad deflation” that forces companies to lower prices as a way of depleting inventory gluts and meet consumer demands. In contrast, “good inflation” involves technological improvements that drive down costs, which can be passed onto consumers, sparking demand. Technological innovation—such as the potential for a dramatic productivity uplift associated with artificial intelligence—may step in to help offset the effects of price declines, and we anticipate many of our portfolio companies to benefit in this scenario—much like technological innovation stepped in to solve problems associated with COVID.

While the Fed may have been over-focused on lagging indicators, it now is forced to reassess economic weakness. The current market shock has given the Fed permission to be more lenient, to loosen more aggressively, to be more sensitive to the systemic risk associated with keeping rates higher for longer. In our view, the Fed will ease, but when? The sentiment within the Fed appears to be shifting, some of its members stating that they will consider new data points that cannot be ignored. The situation may allow investors to lengthen their investment time horizon and to increase their duration.¹²

July 2024 gave us a glimpse of how the market can rotate. The market broadened, the Russell 2000 Index and S&P 500 Equal Weighted Index both outperforming the S&P 500 Index and Nasdaq 100 Index.¹³ We believe that as inflation and interest rates continue to unwind, especially as catalyzed by recent events, the broader market—including off-benchmark names and stocks beyond mega-caps— should have compelling upside potential.

We encourage investors to assess concentration within their portfolios—as well as their existing asset allocation to passive investments or active benchmark-sensitive strategies—and evaluate the potential for ARK’s active strategies to enable diversification away from those concentrations. In our view, investors should diversify portfolios away from the risks associated with concentrated consensus bets. Such diversification historically has tended to benefit performance following a market shock. The markets may broaden out in both the “catch-up” and “catch-down” scenarios observed over the course of last week.

Important Information

The information provided in this material is for informational purposes only and should not be used as the basis for any investment decision and is subject to change without notice. It does not constitute, either explicitly or implicitly, any provision of services or products by ARK, and investors should determine for themselves whether a particular investment management service is suitable for their investment needs. All statements made regarding companies or securities are strictly beliefs and points of view held by ARK and are not endorsements by ARK of any company or security or recommendations by ARK to buy, sell or hold any security. Historical results are not indications of future results. 

Certain of the statements contained in this material may be statements of future expectations and other forward-looking statements that are based on ARK's current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. ARK assumes no obligation to update any forward-looking information. ARK and its clients as well as its related persons may (but do not necessarily) have financial interests in securities or issuers that are discussed. Certain information was obtained from sources that ARK believes to be reliable; however, ARK does not guarantee the accuracy or completeness of any information obtained from any third party. 

Mega-cap stocks are stocks with a capitalization or market value over $200 billion. The companies are the largest publicly traded companies in the world.

The S&P 500 Index is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States.

The S&P 500 Equal Weight Index is the equal-weight version of the widely-used S&P 500 Index (capitalization weighted). The index includes the same constituents as the capitalization weighted S&P 500, but each company in the S&P 500 Equal Weight Index is allocated a fixed weight - or 0.2% of the index total at each quarterly rebalance.

The Nasdaq-100 Index is a stock market index made up of 101 equity securities issued by 100 of the largest non-financial companies listed on the Nasdaq stock exchange.

The Russell 2000 index is a market index composed of 2,000 small-cap companies.