We all remember the fable about Chicken Little who when hit on the head by a falling acorn, decided that the sky was falling—instigating a panic in the community as everyone tried to save themselves from the impending doom. Who would have thought that a possible default in a country the size of Greece would have set off the events of the past week? Particularly since the problems in Greece have been in the news for months.
But, this is how markets work. In the short term, market values are based on perceptions of the future, or in other words, pure psychology. Should we have seen this coming and sold investments? You can’t shoot your herd of cattle just because there is a risk of a stampede! These types of panics can happen at any time.
As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other. Believe it or not, they really do provide a benefit in the form of liquidity and increased market volume. The price we and they pay for this liquidity however is in the form of volatility. What is new is the fact that these gamblers are now armed with increasingly powerful computers driven by computer programs or algorithms designed to exploit minute market movements and to “protect” the gamblers from market falls. If and when these programs all decide, at the same time, that the market is going in the “wrong” direction, they can create awe inspiring market movements like we saw this week.
In response to market volatility in 1987 caused by computer program trading and so called automatic sell programs called “portfolio insurance” the NYSE instituted “circuit breakers” or mandatory pauses in trading. These rules were revised in 1998. The current rules are shown on the website www.nyse.com. Interestingly, no trading halts are set to occur between 2:30PM and 4:00PM ET! It appears that perhaps the new “program trading” algorithms have adapted to this as the “big event” this week occurred after 2:30PM! We may never know exactly what happened, but in an auction market like the stock market—when there are no buyers, prices can get very low, very fast. Especially when computers, not humans are carrying out the bulk of the buys and sells. And, especially with increased potential volume as the result of a dramatically increased activity in derivatives and options. Most likely computer programs began selling and created a vicious cycle as stop loss orders to protect against loss kicked in, creating a tsunami of sell orders with no buy orders until prices fell substantially.
But, this is how markets work. In the short term, market values are based on perceptions of the future, or in other words, pure psychology. Should we have seen this coming and sold investments? You can’t shoot your herd of cattle just because there is a risk of a stampede! These types of panics can happen at any time.
As investors, we have always known that we have to co-exist with “gamblers” or traders who are always trying to make fast money by betting with each other. Believe it or not, they really do provide a benefit in the form of liquidity and increased market volume. The price we and they pay for this liquidity however is in the form of volatility. What is new is the fact that these gamblers are now armed with increasingly powerful computers driven by computer programs or algorithms designed to exploit minute market movements and to “protect” the gamblers from market falls. If and when these programs all decide, at the same time, that the market is going in the “wrong” direction, they can create awe inspiring market movements like we saw this week.
In response to market volatility in 1987 caused by computer program trading and so called automatic sell programs called “portfolio insurance” the NYSE instituted “circuit breakers” or mandatory pauses in trading. These rules were revised in 1998. The current rules are shown on the website www.nyse.com. Interestingly, no trading halts are set to occur between 2:30PM and 4:00PM ET! It appears that perhaps the new “program trading” algorithms have adapted to this as the “big event” this week occurred after 2:30PM! We may never know exactly what happened, but in an auction market like the stock market—when there are no buyers, prices can get very low, very fast. Especially when computers, not humans are carrying out the bulk of the buys and sells. And, especially with increased potential volume as the result of a dramatically increased activity in derivatives and options. Most likely computer programs began selling and created a vicious cycle as stop loss orders to protect against loss kicked in, creating a tsunami of sell orders with no buy orders until prices fell substantially.
Back to the credit crisis concerns about Greece that seemed to light the fuse this week. We have seen this type of thing before. In 1997 we had the Asian Credit Crisis, followed a year later by the Russia’s debt default in 1998. Then in 2001, Argentina defaulted on $132 Billion in sovereign debt—about the same that is at risk in Greece. (Greece’s and Argentina’s economies are about the same. Greece’s economy is only 0.3% of the world’s GDP.)
Let’s put things in a bit of perspective. In early October 1997 the Dow was at 8178. When the Asian Crisis created a reaction, the Dow fell 12.5% to 7161. Eight months later, the Dow had risen 30% to 9328. Reaction to the Russian default in August 1998 caused the Dow to drop 16% to 7827, still 9% higher than the low after the Asian Crisis. The Dow then rose to 11772 by January 2000, falling to 7528 in October 2002. By October 2007, the Dow had risen to 14066. In 10 years from October 1997 to October 2007, the Dow rose from 8178 to 14066, thru three credit crises and a terrible bear market in 2000-2003.
So here we are again with a credit crisis, where fear of contagion causes a bit of panic. The Dow falls 7.4% in days from 11205 on April 26 to 10380 on May 7. Is it over? Probably not yet. The Dow closed at 10325 on the last day of February. Many gamblers may not feel that it is safe to get back into the water until we see a classic 10% “correction”. So, many are probably looking for the Dow to fall at least another 2.3% to 10084. (The Dow was 9908 on 2/8/2010.) Nobody knows for sure when it will change direction. It will change only when the perception of the future changes.
Economic cycles have always more or less been driven by debt. Increased borrowing tends to increase economic growth until the borrowing reaches a point where debtors cannot service it. Then there is a period where debts are restricted or written off and losses are recognized. Decreased borrowing tends to curtail growth.
One big fear is that, even though the US seems to be in a strong economic recovery, that problems in Europe will curtail economic recovery there. And, with a weak Europe, China’s export machine sputters, and the outlook for continued growth in the US is diminished. Another fear is that terrorism is on the rise. Another fear is that governments around the world seem to be taking on too much debt.
It has been said that the most dangerous words related to predicting the future of economies and markets are: “But this time it is different”
The best advice is always to study history and learn from it. Markets in the short term are driven by fear and greed. Market movements are exaggerated by the actions of gamblers. It must be remembered that sovereign debt problems, like unemployment tend to be a lagging indicator, not a leading one. Investors know that markets fluctuate but in the long run, stock markets return to the value determined by corporate profits. Few would argue that corporate profits are not in an upward trend. The debate is really about how fast they will increase. If and when you are confident of the trend, then use the exaggerated market movements caused by fear, greed and the foolish activities of gamblers to your advantage.
If your money is invested for the long term—five years, ten years or more, and you have income or resources to support yourself in the near term, then stay invested. If you have excess resources, then low prices and fear are an invitation for you to profit—the last week has produced a renewed list of opportunities.
If you are a gambler, I can’t help you since I do not provide advice or education to gamblers.
And if you are an investor, when you hear the cries of Chicken Little, tell him he should have a better memory.
This post is for educational purposes and for the sake of discussion. It is not a sales presentation and not a recommendation or personal investment advice. All investing involves significant risk of loss and there is no proven method to eliminate that risk. No investment should be made without a complete due diligence process, fundamental analysis and a discussion with your personal financial advisor.
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