Market Review: What happened?

The major stock markets experienced a dramatic, and difficult to entirely understand, drop in values that at one point pushed the Dow Jones Industrial Average below 10,000 and created the most volatile day since 1987. The Dow ended down 347.8 points, to 10,520.32, which in its own right is extremely concerning. The effect was mirrored on virtually all assets classes, with the notable exception of Gold.

What is particularly baffling is that the reports regarding retail sales, GDP growth, inflation and unemployment have been generally encouraging. In particular, this morning’s unemployment and productivity numbers were better than most economists expected.

Several theories are currently being circulated regarding potential technological sources of the problem – including a suggestion that some kind of order was incorrectly entered on the futures exchanges. While these are likely factors, they probably don’t explain the whole story:

Primary Drivers

We think that the causes of this movement can be attributed to four (primary) short term causes:

1. The Greek parliament voted today in what was expected (and was) a close vote on the fiscal austerity measures proposed by the European Union and International Monetary Fund. (The measure passed around the time the stock market pulled off its lows).
2. A dramatic rally in the Yen today may indicate a massive unwinding of the “carry trade” which may have necessitated a selloff across asset classes.
3. A riot broke out outside of the Greek parliament building (and was reported on Bloomberg television) at approximately the time that the unexpected collapse in stock market prices was occurring. This likely discouraged buyers, who may have cancelled many of their standing buy orders that would have “normally” supported the markets.
4. It appears from exit polls that there will not be a clear winner in the UK parliamentary elections, likely compelling the Conservatives to enter into a coalition government with the Liberal Democrats. The “Lib Dems” are a very new political organization with a somewhat unclear platform. It’s expected that they will force changes on Britain’s overall political system (creating a system of “proportional representation”) that will have unclear effects. Given the UK’s dire economic situation, this is causing a great deal of concern in the European equity markets.

Peripheral Drivers

The general conditions that allowed for a combination of the factors above and technology to create the volatility today are likely:

1. General concerns that the market is “due for a correction” because of the massive rally from March of last year.
2. A pervasive sense that the financial reform bill emerging from the Senate does not address the substantial problems posed by Fannie Mae and Freddie Mac and the awareness that neither government owned companies appear to be getting any healthier.
3. A commonly held belief that the post-recession pattern of growth in the 4^th and 1^st quarters has been anemic relative to the downturn and a long, painful recovery is underway.
4. The loss of NYSE market makers and the rise of algorithmic trading has reduced the average trade size to a mere couple hundred shares. Selling begets selling especially with no referee (market maker) to add stability and liquidity.

 Strategy: A time for courage

Clearly there are temporary factors responsible for the behavior of the markets and technological failure has played some role. Proctor and Gamble’s (PG) stock plunged from an opening of $61.91 / share to $39.37 before closing at $60.75.  This doesn’t make much sense and had we imposed a “sell stop” on PG, this would have been extremely disappointing. The P/E ratio of the S&P 500 is about 17 times earnings – slightly below historical averages and the overall financial health of most companies is quite good.

The volatility of the fixed income markets, particularly for corporate bonds (LQD) and preferred stocks (PFF) doesn’t reflect the strong cash positions that both non-financial and financial companies currently enjoy and lends credence to the view that the events of today reflect “panic” conditions. Historically, investors have not been well served by “bailing out” under such conditions. Consequently, we view the current market action as an opportunity for long term investors to harvest capital losses in taxable accounts and to reallocate to riskier forms of fixed income (like emerging markets bonds, US corporates and bank preferreds).

Our strategy of maintaining minimal allocations to international and emerging markets stocks is unlikely to change. The problems being experienced in Europe are likely to continue, which we expect will have a depressive effect on international equities.

As is always the case, please have no hesitation to give us a call to discuss the impact of today’s events on your portfolios.