Why the wild stock ride?
Barry Ritholtz
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.

~~~

Barry Ritholtz is chief executive of FusionIQ, a quantitative research firm. He is the author of “Bailout Nation” and runs a finance blog, The Big Picture.

Category: Apprenticed Investor, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

21 Responses to “Why the wild stock ride?”

  1. MayorQuimby says:

    This is the danger of pumping markets on low volume. Not that the rally wasn’t justified as earnings did rebound.

    But there is no bid in any substantive way with regards to volume. So when a sell off occurs, the markets will fall precipitously until it finds volume on the bid side. I know a ton of people at my job and MAYBE five percent own any stock. No one can afford to invest right now. So think nominally speaking, the number of new investors is probaby quite low.

    I said it back in 2009. What this country needs desperately is STABILITY. Shut down all the interventions and bailouts, let things correct naturally and we move on. All of this multiple trillion dollar tinkering is just building up more inconsistency, more dependency upon gvmt and much more potential volatility and volatility – either up or down- is BAD.

  2. Jim67545 says:

    Several weeks ago, responding to one of the BR “where is the market headed?” questions I pointed out #1 and #2 above were coming. Acting on that I’ve shorted some things and at least largely offset losses elsewhere.

    Longer term we, as a nation, need to face the fact that the water is (and has been) leaking from our economic bucket and we are not replacing it as fast as it is leaking out. There are a number of sources of leakage from our oil dependency to drug cartels. If you get out of DC or NYC and go to many rural or urban areas around the country you can see them drying up. The drop in housing values, the poor small business sentiment numbers and others are symptoms of this.

    We are dying at the edges, the edges are getting bigger and we are beginning to notice. The recent debt ceiling debate made our plight abundantly clear. We are now reaching the point where we have no choice but to see and can no longer ignore our situation which I would submit is the new ingredient in the market. I suggest that this should be #4 above.

    Up until now we have lamented big corporations holding huge cash balances and asking why they don’t invest in the USA. As if just asking them to is the solution. Now we are beginning to come to the same answer the big businesses would give, if they dared to be candid. The answer is, “why should we?”

  3. Jim67545 says:

    Before I get jumped on for tying the drop in housing values to the economy and not overbuilding/foreclosures, let me add that this is a supply and demand situation. Yes, supply is the biggie but demand is weak too thereby slowing absorbtion of the excess housing units. Bye.

  4. murrayv says:

    Here is an analysis I did for myself a couple of months ago, leading to a major strategic retreat from stocks, just in time:

    Headwinds/risks/exposures facing the economy/stock market at 6/18/11 – not all priced in:
    - End of QE2 – already priced in
    - No arrows left in Fed’s quiver, QE3 unlikely – probably priced in
    - Mortgage market still weighing on banks and consumers – partly priced in
    - Consumer debt way too high – probably not priced in
    - Commodity prices rising – partly priced in
    - Flood related crop declines – little evidence of being priced in
    - Uncertainty about PIIGS, especially Greece – mostly priced in for now
    - Potential for Greek default high – not priced in
    - Hang Seng/Shanghai markets down and dropping – partly priced in
    - Mid-east turmoil – largely priced in
    - Risk of H2 oil shortages – not priced in
    - High unemployment – largely priced in
    - P/Es too high– not priced in
    - Gov’t revenues as % of GDP way too low to support stimulus – not really priced in
    - Congressional gridlock on spending, debt ceiling, tax increases – not priced in
    - Dollar direction uncertain – hard to price in.
    - Corporate margins probably at or near peak – not priced in
    - 6 largest US banks have $1.5T CDS exposure, plus probably >$100B direct bond exposure, mostly to PIIGS, with $40B to Greece – not priced in except partially for bank shares.
    - Mkt. capitalization as % of NGDP (see curves) still way too high. Not at all priced in.
    - Corporate cash hoards not likely to be invested while excess capacity lasts, and low consumer spending not increasing demand much. Investor cash on sidelines unlikely to come in with all of the above uncertainties. – Priced in, but supporting ongoing weakness
    -

    Tailwinds supporting the economy/stock market
    - ONE!! – PIIGS turmoil likely to weaken EURO vs $ and lower oil prices in USA, at least briefly.

    19 bads, 10 not priced in, vs one possible good.

    My Forecast:
    - Market swings short term, (1 to 6 weeks) around modest downtrend.
    - Congress fails to act on debt ceiling before August deadline
    - Market plunges
    - Congress finally acts, but doesn’t do enough to help the economy

  5. jacobsk says:

    On a Mid Cap ETF line chart (MDY), last week never happened

  6. MacroEconomist says:

    Excellent summary.

  7. Barry puts on his professors hat and goes all 101 for his column this week. You are a natural born teacher. Good job

  8. this is a nice Piece, BR..

    really, it should help those that bother to Read, and Reflect upon, it..

    maybe, some of those Individuals will see the similarities between our, current, ‘Stock Market’, and..

    “…The people who design government dietary guidelines are gagged by the fact that politics and business are so tightly intertwined in this country. Their advice will never directly target the primary source of obesity and metabolic dysfunction– industrially processed food– because that would hurt corporate profits in one of the country’s biggest economic sectors. You can only squeeze so much profit out of a carrot, so food engineers design “value-added” ultrapalatable/rewarding foods with a larger profit margin.

    We don’t even have the political will to regulate food advertisements directed at defenseless children, which are systematically training them from an early age to prefer foods that are fattening and unhealthy. This is supposedly out of a “free market” spirit, but that justification is hollow because processed food manufacturers benefit from tax loopholes and major government subsidies, including programs supporting grain production and the employment of disadvantaged citizens (see Fast Food Nation)….”

    Related: Rawsome Farm Buying Club Raided Again

    http://cryptogon.com/?p=24187
    via.. http://wholehealthsource.blogspot.com/2011/07/dietary-guidelines-for-americans-my-way.html

    “Subsidies perturb, more than, Financial, Equilibria..”

  9. rootless says:

    @MayorQuimby:

    I said it back in 2009. What this country needs desperately is STABILITY. Shut down all the interventions and bailouts, let things correct naturally and we move on.

    So the same forces that brought the private credit and housing bubble, and the following bust, crisis and all the misery would have to just let be w/o all the “tinkering”, and these forces would have solved all the problems and everything would be fine again afterward. And everyone else is supposed to take your word for it.

    Where do you take the confirmation from that you were right back then? From anything Barry said in his article?

  10. MayorQuimby says:

    Rootless, think of it this way. You can die a quick death or long drawn out painful one. Which will you choose?

    At any rate, don’t you agree that leaving the same people in charge with the full knowledge that they will pursue the same policies that have repeatedly failed and brought us to the very brink of collapse will do nothing but actually bring on the full collapse?

    It would be one thing if they all came out and stated, “we effed up. And we have learned from our mistakes.”

    No…they are saying we must do MORE of the same things that got us here…excess credit, deficit spending, lowering of rates, destroying existing capital, encouraging speculation….HOW MANY TIMES must we fail at these same childish games before we accept that we are digging a hole and it is getting very very deep?!

  11. praeco.4col says:

    Jim,

    “Up until now we have lamented big corporations holding huge cash balances and asking why they don’t invest in the USA. As if just asking them to is the solution. Now we are beginning to come to the same answer the big businesses would give, if they dared to be candid. The answer is, “why should we?”

    Which leads to the counter-question of why should the people of the United States allow those businesses to remain a solvent, legal enterprise within our borders? Resource-extraction, tax-evasion, judicial and policy manipulation while employing fewer and fewer actual Americans, nor really investing in this country is not the profile of a corporate “citizen”. There is a fine line between laissez-faire and ignoring an increasingly parasitical relationship. The only reason that Marx ever had any theoretical validity at all was because he understood this trajectory of greed and self-serving ignorance. It seems as if the financial sector is doing its level best to kill capitalism these days.

  12. AlexM says:

    Quimby,

    Until you figure out that today’s market is driven by institutions, sovereign wealth funds, and billionaires and not mom and pop investors buying 200 shares at a time at your place of employment you will be forever lost. Individual investors do not drive the market and haven’t for decades.

  13. Chief Tomahawk says:

    Wow, that really tame compared to last week’s “Man the Lifeboats”!

  14. rootless says:

    @MayorQuimby:

    Rootless, think of it this way. You can die a quick death or long drawn out painful one. Which will you choose?

    What a strange analogy. Is this how you see it? The choice in 2009 was between a “quick death” or a “long drawn one”? When you are dead you are just dead. There isn’t anything after that. So that’s why you support the Tea Party lunacy? Since you have a death wish, you are yearning for the collapse of society. That’s why your arguments don’t make any sense, if one tries to approach this rationally. It’s just irrational lunacy.

    No further questions.

  15. AHodge says:

    so im the other way and have gone from nothin to somethin starting last tues early market.
    for reasoned laid out last week and i also think less two way vol next week
    happy trading

  16. sparky says:

    Looks like Sherry Cooper at BMO is pretty consistent with BR’s outlook

    http://www.montrealgazette.com/business/cuts+forecast/5250407/story.html

  17. philipat says:

    Barry, correct me if I am wrong (I might have blinked sometime during last week) but we have already HAD a 15-20% correction. Did you mean another 15-20% from here? That would get us back below the normalised Schiller P/E norm of 16X. Of course, markets normally overshoot………………………………………………………….!!

  18. AlexM says:

    @philipat,

    I believe he is saying that this might be the end of the current correction, or we might go down to 25% from here.

  19. philipat says:

    @AlexM

    Which one? That was my point!!

  20. DeDude says:

    Rootless;

    Some people suffer from the Armageddon complex believing that in order to “fix” things we must first have a total “cleansing” apocalyptic collapse that will get rid of everything (good and bad). Only after that has happened will it be possible to build anew and this new thing will (magically) be good and clean and right. As so many other moronic ideas it is an ideology and is not based on any facts, experiences or logic. It is more than anything else build on frustration with not being able to “repair” a current situation mixed with a desire to “punish” everybody for not backing a specific “repair” plan. The two main problems with this ideology is 1) the idea that somehow all the old flaws would “magically” be understood and ejected from the rebuilding process, and, 2) the failure to understand that there is a substantial cost from (collateral) damage that only occurs in “collapse”, not in “reform” processes.

  21. AlexM says:

    philipat,

    That was Barry’s point – no one can know exactly where we are going from here, but these are the parameters. I didn’t see it as an either/or selection.