Another August Scare Hits the Stock Market. Investing Lessons Can Be Found Here.

The month of August often brings a sense of unease for investors, as it has historically been a time of unexpected market turbulence. The lazy days of summer can quickly turn into a financial storm, as past events like Iraq's 1990 invasion of Kuwait, the 1991 attempted coup against Soviet leader Mikhail Gorbachev, and the 2011 downgrade of the U.S. credit rating by Standard & Poor’s have shown. This August was no exception, with the stock market experiencing a sudden surge in volatility right from the start.

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The month kicked off with a three-day downturn in stocks, culminating on the first Monday with a significant 3% drop in the S&P 500. This marked the index's largest single-day decline in nearly two years. The following Tuesday saw a brief recovery, though stocks still closed below their opening levels. Wednesday brought more instability, as early gains evaporated by the close. However, the week ended on a high note for the S&P 500, which recorded its best back-to-back performance of the year, including its strongest single-day gain since 2022 on Thursday.

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By the time the markets closed on Friday, the S&P 500 had managed to break even for the week, while the Dow Jones Industrial Average, which had plunged over 1,000 points on Monday, ended the week with a relatively modest loss of 240 points, or 0.6%. The Nasdaq Composite fared slightly better, trimming its weekly decline to just 0.2%. Despite the turbulence, the S&P 500 remains up by more than 12% year-to-date.

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While some might dismiss this drop as a brief summer storm, the selloff has raised questions about whether investors’ bullish expectations regarding artificial intelligence, economic prospects, and other factors might be overly optimistic. However, some market watchers viewed the decline as a necessary and even beneficial adjustment.

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Carol Schleif, chief investment officer at BMO Family Office, described the recent pullback as a "constructive reset." She noted that while the market's 3% drop on Monday might have seemed alarming, what was truly noteworthy was how calm the market had been for such an extended period. Nassim Nicholas Taleb, an author and risk expert, echoed this sentiment, suggesting that the absence of regular 3% pullbacks was more of a “black swan” event—a term used to describe rare, unpredictable occurrences with significant consequences—than the pullback itself.

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One reason the recent decline felt so unsettling is that prolonged periods of market calm can make even routine corrections seem more severe than they are. Various factors contribute to these extended periods of tranquility, including popular options-selling strategies and related products that can suppress volatility but may lead to sharp reversals when they eventually snap back.

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The spike in volatility was evident in the Cboe Volatility Index (VIX), often referred to as Wall Street's "fear gauge." Over just three days, the VIX more than doubled, climbing from 16.4 on Thursday to a close of 38.6 on Monday. This kind of move in the VIX or its predecessors has occurred only four times in history. During Monday’s session, the VIX soared above 65 at its intraday peak, signaling extreme market anxiety.

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Such dramatic movements in the VIX are usually associated with significant market disruptions, often more severe than what U.S. stocks experienced this time. However, the situation was more dire in Japan, where the Nikkei 225 index suffered a 12% drop on Monday, its largest one-day decline since the 1987 U.S. stock market crash. The Nikkei did manage to claw back some of those losses by the end of the week.

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The selloff appeared to be triggered by a series of disappointing U.S. economic reports, starting with an Institute for Supply Management manufacturing index that slipped back into contraction territory on August 1. The selling pressure intensified the next day with a weaker-than-expected July jobs report, which reignited fears of a recession and prompted criticism that the Federal Reserve had made a policy error by not cutting interest rates at its July meeting. Panicked traders began pricing in the possibility of an emergency rate cut and more significant rate reductions in the coming months.

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Adding to the turmoil was a rate hike by the Bank of Japan on July 31, which was blamed for exacerbating the selloff. The subsequent strengthening of the Japanese yen accelerated the unwinding of the "yen carry trade," where investors borrow in low-yielding yen to invest in higher-yielding assets, potentially including U.S. tech stocks.

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While the exact role of the yen carry trade in the U.S. stock market's decline remains debatable, it certainly contributed to the overall sense of unease. However, remarks from a senior Bank of Japan official on Tuesday, assuring that policymakers would avoid raising rates during financial turmoil, helped to calm global markets.

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As quickly as weak economic data sparked the selloff, stronger reports helped to soothe investors’ nerves. A positive reading from the ISM services index on Monday and a drop in first-time weekly jobless claims on Thursday eased recession fears. As a result, expectations for an emergency interest rate cut faded, and the likelihood of a large rate cut at the Federal Reserve's September meeting dropped to less than 50%, down from 74% the previous Friday, according to the CME FedWatch Tool.

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Schleif noted that while the rebound was encouraging, investors should be cautious as volatility spikes typically don't resolve themselves so quickly. Markets often remain unsettled for weeks, and Monday's lows could become important support levels that may be tested again.

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Raymond James’ chief investment officer Larry Adam emphasized the importance of avoiding panic during volatile periods. Panic selling can be costly, as some of the strongest market gains often follow the sharpest declines. For example, Monday’s 3% drop in the S&P 500 was followed by a 1% gain on Tuesday and a 2.3% gain on Thursday, the strongest since November 2022.

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Adam pointed out that missing the best trading days, which often come right after significant sell-offs, can significantly impact long-term returns. Over the past 50 years, missing just the ten best trading days would have reduced average returns by 1.7%, from 8.3% to 6.6%.

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Schleif advised that the recent market turbulence offered a valuable lesson for investors. She highlighted the importance of building a resilient portfolio and not overreacting to single data points, such as the jobs report. Instead, she suggested waiting a day or two for the market to settle before making any decisions.

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