The Recent Sell-Off is Proof That Narrative Moves Stocks

Shah Gilani|August 23, 2024

It’s easy to think that stocks and markets are governed by cold, hard fundamentals. But that simply isn’t true.

Especially these days.

Stocks, whose prices are outwardly determined by traders’ buying and selling decisions, are really driven by narratives.

Narratives, as we’ve discussed, are the stories crafted by analysts, talking heads in the financial media, and market participants themselves.

We’ve just seen a dramatic illustration of this dynamic with the rise of markets on the “AI will reshape the world and company prospects and profits” narrative… and then the fall of markets on the countervailing narrative that companies have overspent on AI and some may never see a return on their capital expenditures.

Understanding how narratives can lead to moves like these is key for traders seeking to navigate modern markets.

The AI Boom and the Bull Market Surge

The narrative of AI has been one of the most potent drivers of market sentiment in recent years. When the Federal Reserve hiked interest rates, many expected the bull market to cool down. After all, higher rates typically dampen borrowing and spending, leading to reduced corporate profits and lower stock prices.

Yet, against this backdrop of tightening monetary policy, a new narrative emerged…

The AI narrative was bigger than interest rates, bigger than inflation. AI was set to change the world and, by extension, propel AI-centric stocks – and the market – to new heights.

The narrative was powerful. Prominent technology stocks – particularly the Magnificent 7 – were touted as the leaders in AI innovation. The grand narrative had it that these companies would harness AI to boost their productivity, create new revenue streams, and fundamentally transform their business models.

The hype around AI was so intense that it seemed like it could overcome the negative effects of rising interest rates. And it did. With the exception of Tesla (TSLA), the Magnificent 7, along with market benchmarks heavily weighted with Mag 7 and AI-centric stocks, rose in the face of a Fed hiking regime.

The stock market surged to new highs in July 2024. The argument was compelling: If AI could revolutionize entire industries and generate unprecedented profits, then higher rates were a small price to pay for participating in this transformative wave.

Investors eagerly bought into the narrative, pushing valuations to lofty levels.

But ripe fruit soon spoils…

The Shift in Narrative: AI’s Long Road to Profitability

Narratives are not static. Sometimes they evolve as new information comes to light and as market dynamics shift. And sometimes they remain intact but become layered over with sub-narratives.

Sometimes they just die out.

As we moved into August 2024, a new AI narrative layer began to emerge… one that questioned the immediate benefits of AI and highlighted challenges faced by some of the Mag 7 stocks.

The new narrative was that despite massive investments in AI, the leadership stocks might not be able to monetize their AI initiatives for years, if ever.

The financial media ran with this story, suggesting that while AI might be a revolutionary technology, the path to profitability was fraught with obstacles. High valuations, coupled with the slow realization of AI’s financial benefits were seen as reasons for concern.

This narrative shift gained traction as the leadership stocks driving the market to its July highs sold off alarmingly from mid-July into August.

Valuation concerns, combined with the narrative of AI’s delayed monetization, was thought to be the reason for the selloff.

That isn’t what was really happening, though.

The Real Driver of the Selloff: The Yen Carry Trade

While the fresh narrative layer about AI certainly contributed to the market’s volatility, it wasn’t the whole story. In fact, it wasn’t even a whole truth. It was a made-up narrative.

The truth is – or I should say was – analysts, financial talking heads and the media manufactured that layered narrative to explain the rollover of mega-caps and AI-related stars.

What was really knocking down the leadership stocks was the unwinding of the yen carry trade.

I talked about this in my Monday Takeaways. The trade involves borrowing in yen (which has low interest rates) and investing in higher-yielding assets elsewhere. It’s been a popular strategy since the Japanese yen has been so “cheap” relative to other currencies.

The new carry trade (carry is Wall Street lingo for financing your book of positions) was financed by selling yen and investing the proceeds in the Mag 7 and other AI highfliers.

However, as the Fed’s rate hikes began to take hold, interest rate differentials between the yen and other currencies changed. Since late spring of this year, the Bank of Japan started jawboning the idea of raising rates in Japan. This would raise the value of the yen relative to other currencies.

Smart traders heavily leveraged in the yen carry/long Mag 7 trade began to unwind their positions, buying back yen and simultaneously taking profits on their stock positions.

That’s what really started knocking down the leadership stocks, not the layered narrative about AI overspending. The trouble is… the media and investors at-large didn’t know about the yen carry trade.

Therefore, there was no narrative awareness about it.

Then the Bank of Japan actually raised rates and the yen soared. That’s when institutional traders en masse had to cover their short yen positions and dump their Mag 7 and other stocks.

The yen carry trade exacerbated the selloff in stocks that were already under pressure from the new AI profitability narrative. The combined effect of these factors led to a sharp correction in August, catching many investors off guard.

It illustrated exactly what can happen when you don’t have a firm grip on all the narratives at play.

The Importance of Understanding Market Narratives

Understanding the prevailing narratives – and how they shift – is essential for making informed trading and investment decisions. The best traders know how to dig through data and read between lines looking for shadow narratives. Here’s why:

• Narratives shape sentiment: When a narrative gains traction, it can create momentum in the markets. Conversely, when a narrative shifts or new information emerges, it can lead to rapid changes in market direction.
• Timing of narrative shifts is critical: In the case of AI, the narrative that drove the market up was potent… but then a new layer on top of that narrative gave it a shelf life. When the narrative shifted to concerns about AI profitability, it triggered a selloff. But the real selling came from the yen carry unwind, a between-the-lines narrative that only big traders in the carry trade understood. Being attuned to all these narrative changes can help traders position themselves ahead of the market.
• Narratives don’t always align with fundamentals: It’s essential to balance narrative-driven trading with a grounding in valuation and financial fundamentals. In the recent case, high valuations coupled with concerns about delayed AI monetization led to a reassessment of stock prices. But because the fundamentals of the leadership stocks are so great, they rebounded quickly.
• Global factors impact narratives (and prices): The yen carry trade’s unwinding is a prime example of how global financial dynamics can influence narratives, market sentiment and stock valuations.

The recent market movements driven by the AI boom, the Fed’s rate hikes, and the yen carry trade underscore the power of narratives.

Traders and investors must always remain vigilant about the narratives being pushed by analysts and media. These narratives can create opportunities… or pose risks. It ultimately depends on how well you understand and anticipate them.

Stay informed and adaptable. Do this and you can better position yourself to navigate the complexities of modern markets and capitalize on emerging trends.