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On Monday, the Nikkei index plummeted by 12.4%, erasing a 14-month gain in a single day and returning to levels last seen at the end of May and the beginning of June last year. Moreover, this marked the largest single-day drop in the Nikkei's history.

It's worth noting that since the inception of the NASDAQ index, the largest one-day decline was only 12.3%, which occurred during the pandemic impact in 2020. The S&P has only seen a larger drop once, on the infamous "Black Monday" of October 19, 1987.

Today, global investors faced another "Black Monday."

Everyone would say that the sharp decline in Japanese stocks is closely related to the reversal of the yen carry trade, with the yen shifting from depreciation to appreciation. However, few have addressed a key question: at the end of 2022, the yen rebounded by 16%, and by 7% at the end of 2023. Although the Nikkei index also fell during those times, the extent was very limited. Recently, the yen has only appreciated by 13%, so why has the Japanese stock market correction been so severe?

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It turns out that the main institutions engaged in carry trades are Japanese overseas insurance companies. Although carry trades are simple and effective in making money, they do carry exchange rate risks. Therefore, insurance companies take measures to hedge these risks, primarily through forward contracts, currency swaps, and put option trades.

The performance income reports of the nine largest life insurance companies in Japan, as of March 31 of this year, show that as much as 47% of these companies' overseas securities are covered by hedging derivatives.

However, this figure is actually the lowest since September 2011, with the peak at 63% in March 2020. Due to the continuous depreciation of the yen against the US dollar before July, these insurance companies likely further reduced their hedging ratios, betting on further depreciation of the yen against the US dollar.

But things did not go as planned. Starting in July, uncertainty surrounding the US election and the capital market increased significantly. Institutions lending yen demanded that investors reduce their yen positions, and the yen strengthened against the US dollar, catching these insurance companies, which lacked sufficient exchange rate risk hedging and suffered losses, off guard.

Now, these overseas insurance companies need to buy yen to repay, and the yen may appreciate to a level of around 130. Therefore, the yen's appreciation could reach 20%-25%, significantly exceeding the levels at the end of 2022 and 2023. This will greatly affect Japanese listed companies that are highly dependent on overseas income. Since shorting the yen and going long on Japanese stocks are the most crowded trades, this has led to a plunge in the Japanese stock market on Monday.

The Nikkei has fallen by 25% from its yearly peak, taking only 17 trading days. Historically, there have been only four times when the Nikkei has fallen more than 20% in such a short period, in 1990, 2008, 2013, and 2020. But in those four instances, the maximum decline in a three-week period was only 23%, showing how fierce the recent drop has been.From a trading perspective, rather than entering the market now to buy Japanese stocks for a short-term rebound, it would be better to continue observing the trend of the yen. The market currently believes that the Federal Reserve may suddenly announce an early interest rate cut. I explained in my previous video that this kind of rescue-type rate cut is very helpful for the stock market.

As of last Friday, the S&P and Nasdaq have also corrected 6% and 11% from their peaks, respectively. I anticipated the trend of the U.S. stock market in my recent video and provided clear reasons.

Regarding the U.S. stocks, there are two opposing views in the market. One view is that U.S. stocks will continue to plummet, repeating the collapse of the internet bubble in 2000 and the financial crisis in 2008. The other view is that there is no obvious bubble in U.S. stocks, and the earnings of listed companies are quite good. As long as the Federal Reserve decisively cuts interest rates, new highs will be set by the end of the year.

I offer four points for everyone's reference. First, the current decline in U.S. stocks is completely normal. Looking at the historical data from 1928 to 2023, the probability of the S&P index falling more than 10%, 15%, and 20% within a year is as high as 64%, 40%, and 26%, respectively.

From 1980 to 2023, the average maximum drawdown of the U.S. stock market from its yearly high is 14.2%. Therefore, there is no need to be alarmed by the current 6% decline in the S&P.

Second, from 2023 to 2024, the stock market has also seen an extremely rare anomaly, which is that the daily price fluctuations almost all fall within the range of -2% to 2%. The last time such a situation occurred was throughout 2017, when 99% of global asset prices rose. I believe that the extremely optimistic market sentiment created a once-in-a-century low volatility trend. This trend will not continue in 2018, and the stock market will plummet.

The result turned out to be a self-fulfilling prophecy, with 93% of global assets falling in 2018, once again presenting a once-in-a-century scenario.

Third, using the earnings of listed companies to judge the medium and long-term trend of the stock market is very helpful, but it is of little use in the short term. This is because the biggest challenge the market is currently facing is the "crowding crisis," which is the reversal of the most concentrated trades of being long on tech giants and short on the yen. When a fire breaks out, everyone is trying to escape.The most significant impact on the stock market comes from the mutual reinforcement following the deterioration of market and financing liquidity. A stampede of people can lead to insufficient market liquidity, and successful transactions require high costs. Financial institutions, acting as intermediaries, will demand that investors reduce leverage or cut off financing to protect their interests, thus creating a vicious cycle. In fact, the fundamental logic behind every market crash is the same.

Fourthly, while theoretically interest rate cuts are beneficial to the stock market, they are almost always a harbinger of recession. Once combined with high market concentration or hidden crises, even interest rate cuts cannot prevent the market from falling.

After the United States cut interest rates in 2000 and 2007, the U.S. stock market continued to decline.

Looking at the rising unemployment rate, it is highly probable that the U.S. economy has already entered a recession, which will exacerbate the crisis facing commercial real estate. Although it may not be as severe as the 2007 residential real estate crisis, the market may not have given it sufficient attention.

Another crisis that has not been fully priced in by the market is the fierce competition between the two major U.S. political parties in the elections.

Overall, I still recommend that everyone should be cautious, reduce the proportion of stock market allocations that have seen significant gains in the past, and increase the allocation of defensive sectors such as consumer staples, healthcare, and utilities, as well as assets like government bonds and gold. In fact, these assets have performed relatively well recently.

Of course, this black swan event also reminds everyone that strategic and tactical asset allocation is far more important than focusing on a single track. To navigate through bull and bear markets, one needs to diversify across multiple tracks and varieties. Withstanding downturns allows for better upward movements.