Why the wild stock ride?
Washington Post: August 6
Here is last week’s WaPo column:
Here we go again.
The markets had a tumultuous week, flipping negative on the year and taking down investors with it.
Back in April, you may recall, we discussed having a plan for these all-too-regular market convulsions (“Anticipating the next Black Swan”). You did set up an exit strategy after reading that, right? If not, last week’s ride should inspire you to get in gear. Let’s look at why this happened and what you should be doing about it.
After Congress and the president reached a debt-ceiling deal, markets applauded. Last Sunday night saw Dow futures up 171. It looked as though equities were ready to shake off their July malaise and power higher.
The economic data, however, threw a monkey wrench into traders’ plans. On Monday, the Institute of Supply Management survey of purchase managers came in at 50.9 — a very soft number. Jim Bianco of Bianco Research noted it was “below the weakest guess of all Bloomberg-surveyed economists.”
Markets retrenched, giving up all of their gains by midday and going negative at the close. Technical types call this action an intra-day reversal, and it rarely bodes well for near-term market action.
Lately, that negative economic drumbeat has been par for the course. Over the past few months, economic numbers have continually softened. Employment, retail sales, manufacturing, services, confidence and gross domestic product have all showed signs of slowdown. Friday’s non-farm payrolls data was an upside surprise of 117,000 net jobs — but under normal circumstances, that’s a disappointing number. It’s below what is necessary to keep up with population growth. That markets initially rallied on it tells us something about how low expectations have fallen.
Why have markets suddenly turned so skittish? It is not as if any of the usual suspects have been unknowns. The problems in Europe were well understood; the PIIG countries (Portugal, Italy, Ireland, Greece) are just as insolvent today as they were a week, a month or a year ago. The end of QE2 was not sprung on anyone. The Fed’s liquidity program was scheduled to end June 30, a date markets knew many months ago. And no one on Wall Street really believed Congress would allow the debt ceiling to cause a U.S. default.
All of the above are after-the-fact rationales — excuses for what pundits cannot easily explain.
So what was last week’s mess really about?
I can think of three possible explanations:
1 Earnings: Markets are belatedly pricing in a weaker economy and softening earnings. (I am hard-pressed to explain why it took so many weeks for investors to recognize this.) Earnings have been the one major data point that has stayed positive. With soft hiring and weak retail sales, there is a recognition that the economy is losing steam. That will eventually pressure earnings.
2 Government stimulus is ending: You can credit government intervention for most of what was working well. Look at the sectors in the economy that have been performing: autos (cash for clunkers), housing (first-time home buyer credit, mortgage modifications), exports and manufacturing (weak dollar) and retail sales (payroll tax cuts). All these sectors have seen their government stimulus disappear, and they’ve faltered without it.
As the political will for more bailouts and interventions dissipates, so too do expectations for further gains.
3 Too far too fast: No doubt, this has been a ferocious bull cycle. From the March 2009 lows, the markets have gained nearly 100 percent in two years. Such gains in so short a period have only happened twice before — 1933 and 1938. In both cases, markets subsequently gave back nearly all of their gains.
Traders are an optimistic lot, and they give the bull market the benefit of the doubt. These cyclical rallies tend to run longer and go further than most people expect, and this rally was no different. But eventually, traders have to accept that the economy moves in cycles, and it may be that this one is ending.
Where does this leave us?
Last week’s havoc should be looked at as a warning shot across investors’ bows. The disruptions signal a major change in risk appetites — the willingness of large institutional buyers of stocks to continue accumulating equities.
The changing economic data make a recession less of a long shot and more of a real possibility. The standard cyclical recession causes a market correction of about eight months and a market drop of about 20 percent.
Those are just the median numbers. But they suggest that investors may get more defensive. On Monday, for instance, we cut loose our highest beta names (those with high volatility relative to the market) — selling emerging market, small-cap and technology stocks. We are now about 50 percent cash and bonds, with our equity holdings mostly value and dividend payers that tend to withstand sell-offs better than more volatile names.
The odds of a 15 to 25 percent correction are now increasingly likely. Investors should adjust their risk parameters accordingly.