Nearly lost in the turmoil surrounding last Thursday’s epic intraday stock market plunge and recovery is the fact that the stock market was already falling when it happened. Stocks finished the week down roughly 6% and the S&P 500 finished the week 8.7% from the high it set just recently. Even after last week’s gyrations we still have yet to see a real 10% correction since the rally started last year – if you don’t count the low recorded during the weird computer driven snafu of Thursday afternoon. So the correction so far is pretty run of the mill even if the volatility is not. Now investors face two questions. Is this just a correction or the start of something bigger? And what the heck happened Thursday afternoon and what does it mean?
Let’s look at the second question first. I would love to tell you that I know exactly what happened Thursday afternoon but I can’t. Apparently neither can anyone else at the moment. The exchanges and the regulators are still trying to piece together the events that precipitated a roughly 700 point selloff in a matter of minutes Thursday afternoon. There were rumors initially of a so called fat finger trade but so far there is no evidence of a trading error. We’ve had those before and it has never taken very long to determine who the guilty party was so if no one has emerged yet as a culprit I suspect there won’t be one. The other prime suspects are the computerized trading systems that are associated with High Frequency trading and other black box type systems. These HFT systems have been justified in the past as liquidity providers but that sure didn’t prove true Thursday afternoon. When large blocks of stock were brought to market there were no bidders, computerized or otherwise.
I have heard a number of explanations about how computerized trading systems caused the problem. I don’t know which explanation to believe but at some point Thursday either the computers took over completely or they stopped trading altogether. Some have told me that the selling was due to computer driven quantitative strategies that keyed off a rising yen to generate massive sell orders in US stocks. Others believe the problem was that the High Frequency Trading programs shut down and backed away from the ECNs just as the NYSE slowed trading. Which is true? I don’t know but somebody needs to figure it out pronto because public confidence in markets, already pretty low, is now approaching non existent. The perception that Wall Street is nothing more than a casino where the odds are stacked against the little guy is beginning to look like more than just a perception.
At some point we need to confront the reality that much of the trading that goes on in our markets is nothing more than gambling with little if any social value. When competitive advantage is measured in nanoseconds and profit in fractions of a penny, how does one value the benefit to investors or the economy? Stock markets are important to our economy because they facilitate the allocation of capital. They allow companies to raise new capital for expansion and they allow investors to make long term investments while retaining liquidity. There is a real benefit to the economy when stock markets function correctly, but when they become mere casinos, the useful functions get pushed to the background. It is not coincidence that several Initial Public Offerings were canceled last week due to ”market conditions”. When markets cannot fullfill their primary mission of raising capital for real companies making real products, something is drastically wrong. I don’t know what, if any, regulations are needed to maximize our markets useful functions while limiting the gambling aspects but hopefully someone is working on it because there are long term consequences for the economy if the capital raising function is impaired.
So is this a correction or the start of something more? As I’ve said repeatedly over the last few months, the underlying problems in our economy have not been solved and what is going on in Greece should be a reminder that if we don’t take the necessary steps to rein in our addiction to debt, the market will force the issue at some point just as it has in Greece. The economic consequences of the Greek debt problem are difficult to ascertain at this point. The Greek economy is only about 2% of the EU economy so a further deepening of the Greek recession would not seem significant, but the larger concern for markets at this point is the possibility that the Greek problem becomes a Portuguese problem and then a Spanish problem and an Irish problem, ad infinitum until the EU experiment comes completely unglued and the Greeks go back to defaulting on their debt and devaluing the Drachma as they have for the last hundred years or so.
It is hard to say at this point whether Europe will find a way to avoid the contagion scenario but I suspect they will at least in the short term. The politicians of the EU have too much to lose if they don’t find a way to paper over the hole in the PIIGS balance sheets. The finance ministers are meeting today to formulate a plan to stabilize the situation and the ECB will probably announce something as well. The ECB, by the way, is prohibited from directly purchasing any EU members debt as many were urging last week. My guess is that the ECB will find a way to accomplish the same thing while sticking to the letter of the law.
No matter what the countries of the EU do to stop the contagion in the short term, the long term solution is obvious. The Greeks will be forced, one way or the other, to balance their budget. How they go about that will determine the degree of pain endured by the Greek people. If they reduce government spending while enacting reforms that spur job creation in the private sector the pain can be minimized. If, as seems more likely, they try – or are forced – to balance the budget mostly through tax increases, they are in for years of austerity. Spain, Italy and the other countries with the worst fiscal situations need to enact positive reforms before the IMF arrives bearing gifts of low interest loans and high taxes.
And the US needs to pay attention as well. The IMF won’t be knocking on our door anytime soon but if we don’t start to get our house in order, the bond vigilantes will eventually find their way to the US market. Rapidly rising interest rates and a free falling currency are a recipe for stagflation, as we discovered in the 1970s. There has to be a fiscal tightening of some kind in the near future and we can choose to either cut government spending, raise taxes or some combination of the two. Then we need to look at ways, other than just further easing monetary policy, to positively affect economic growth in the context of lower deficits or balanced budgets. These could include major tax reform that shifts more of the tax burden from income and capital to consumption or changes in the corporate tax code that favor investment.
Markets were already on edge and ready for a correction before last week. We do not know yet the extent of the effect on the US economy of the situation in Europe but a slowdown there will have an impact here. China is also trying to slow their economy to head off inflation. The market is trying to quantify the degree of economic slowdown as well as the likelihood of further debt problems in other countries. It is a very uncertain time and until the uncertainty lifts a bit the volatility will continue. For now, my expectation is that the fallout from Europe will be minimal and the US economic recovery will continue. Having raised cash over the last few weeks I am now building a list of stocks and ETFs to buy when some clarity returns to the economic situation. Hopefully that will be soon.
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