The hidden risk behind the next market correction

You would be surprised how often the trigger for market volatility comes out of left field. While everyone is looking for trouble in one direction, the catalyst sneaks up behind you. We have all been fretting about AI and the Gulf, inflation and rising interest rates, but perhaps the real risk is something we’ve only just started talking about - the relentless slide in the Japanese yen.

Treasury Secretary Scott Bessent certainly thinks so. Why else would he have scribbled a ‘note to self’ to buy $5-10bn of the Japanese currency and - silly me - left it for the press to photograph? Why else would the US have made the most unexpected intervention in the foreign exchange market for 30 years?

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The yen-dollar exchange rate matters to Japan. A weak currency risks turning the country’s long-awaited reflation into imported inflation. But it matters more to the US. That is because the main way that Japan might boost its own currency is to sell the other side of the trade - US dollars, and specifically US Treasury bonds.

Japan is the biggest overseas holder of this foundation stone of the global financial system. It owns about 4% of America’s outstanding debt. With 30-year US government bonds already yielding more than 5%, and the national credit card maxed out, the last thing Washington needs is a new source of supply pushing yields higher still. Bessent’s transparent support for the yen sends a simple message to anyone thinking they might like to force Tokyo into a corner: Back Off.

Delve into any of the periods of market volatility over the last 40 years and you will quickly find a forced or otherwise price-insensitive seller. Howard Marks made his fortune buying what other people were selling because they had run out of time, money or patience. He said: ‘buying from forced sellers is the best thing…being a forced seller is the worst.’

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Forced selling is the common thread that runs through every financial crisis I can remember. In 1998 when Russia defaulted on its debts, it was not a systemically important economy. The real issue was Long Term Capital Management, a hedge fund with staggering levels of balance sheet leverage. When the Russian default caused assets to behave in unexpected ways, its trades began to unravel. Banks suddenly realised that they all had exposure to the same failing fund.

The point is not that Japan is another LTCM. It is not. The point is that markets correct not because of the headline event but because of the way in which it exposes a forced seller.

Sometimes the forced selling is a by-product of the structure of the market rather than deteriorating fundamentals. The 1987 stock market crash, right at the beginning of my career, is the best-known example of this. The culprit then was a newish risk management technique called portfolio insurance - a mechanised system of selling stock index futures as markets fell.

Investors thought they could replicate a put option by dynamically selling those derivatives as prices fell. It would have been a great idea if only a few of them were doing it. In practice, of course, everyone tried to hedge at the same time. The Japanese authorities are not about to trigger another Black Monday. But history suggests that the key question is not what the next shock will be but who will have to sell if it happens.

A good example more recently, and closer to home, was the 2022 mini-budget crisis. Again, the government’s unfunded spending promises were only part of the story. The real issue was the leveraged liability-driven investment strategies implemented by the UK’s pension funds. Higher gilt yields triggered margin calls. And funds became forced sellers of gilts. That pushed yields higher still. Which created more margin calls. It was 1987 all over again. Hidden leverage, forced selling and a scary feedback loop.

Fast forward to today and the carnage in the Korean stock market can be partly explained once again by forced sellers. It has echoes of the previous episodes. Once momentum reverses, leveraged ETFs rebalance, options dealers adjust their hedges and volatility targeting funds reduce their exposure. At that point, few participants are asking what SK Hynix or Samsung is actually worth. They are simply following the rules.

Ordinary corrections become something uglier when investors stop assessing value and instead chase liquidity. Whether you are a professional investor or running your own portfolio, you never, ever want to be selling because you need the money.

There is an important lesson here for ordinary investors. We can’t control what triggers the next correction. But we can control whether we are one of the people who make it worse.

Seth Klarman, who wrote the very-limited-edition value investing guide Margin of Safety, was happy to hold billions of dollars in cash even while markets were rising. His point was that cash is not there to outperform in the good times. It is there to ensure you never become a forced seller in the bad ones.

Although it is Japan that looks like the forced seller in this latest currency wobble, in reality it may be the US. Decades of living beyond its means have left it reliant on the kindness of strangers. Which is fine until those strangers find themselves in the same straitened circumstances.

As individual investors, we do not have the luxury of leaving unsubtle messages for the photographers to snap. We can’t manage the market, but we can protect ourselves from it. As Howard Marks said: ‘it is essential to arrange your affairs so you’ll be able to hold on - and not sell - at the worst of times.’

The next correction will almost certainly produce forced sellers. Your job is to make sure you are not one of them.

This article was originally published in The Telegraph.

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