Flash Crash Lite
Let’s call it “Flash Crash Lite.
”The Dow Jones Industrial Average plummeted more than 500 points yesterday – plunging the Blue Chip index into the red for 2011…and plunging a dagger into the hopes that the “debt ceiling” vote would put a floor under the stock market.
No one really has any idea why the stock market tanked yesterday, but almost everyone has an explanation. Some blame Europe, others cite signs of economic weakness here home, and still others link the falling stock market to “generally gloomy conditions.”
Jeff Macke, writing for Yahoo Finance, summarizes the situation fairly succinctly:
There’s a growing realization among even the most optimistic investors that the United States is entering a new recession — a dreaded “double-dip.” Adding to the pain is the sense that the government and Federal Reserve are out of both ideas and ways to stimulate the economy. Corporate America is sitting on record amounts of cash but is refusing to make new investments with so little end demand for its products. Consumers and corporations are hoarding cash, and the economy appears to be seizing. The debt ceiling debate was a fiasco, snuffing any remaining confidence traders had for help from Washington, D.C.
The bottom line is traders are becoming convinced that we’re facing a prolonged and severe recession, and there’s nothing any government on Earth can do to stop it. In that context, selling stocks or “reducing exposure” as they say on Wall Street, is quite rational.
Or at least not completely irrational…
Here at the Daily Reckoning, we will advance no explanations for the mini-panic that is underway. Instead, we will merely observe that a sluggish U.S. economy and a fracturing European economic union provide little incentive to buy stocks.
But as lethargic as the US economy has been, and as uninspiring its stock market, the US looks like a rock alongside its European counterparts. For example, even though the Dow finally dipped into negative territory for the year-to-date yesterday, most European markets are down double-digits for the year.
Doing “better than bad” is small comfort, but it is some comfort. The poorly performing European stock markets reflect both widespread economic anemia and deteriorating public finances in several European countries.
Fifteen years ago, Morgan Stanley’s Investment Strategist, Byron Wien, quipped, “Unless Europe engages in an extensive program of restructuring, in 20 years it will be a vast open-air museum.”
Europe is not a museum…yet, but it might want to begin interviewing prospective docents. The European private sector is growing slowly, if at all, while the public sector is struggling mightily to pay its bills. Signs of economic distress in the old World are increasing by the day. Some call it “Eurosclerosis.” The pricing of credit default swaps (CDS) provides some insight.
A CDS, as regular readers may recall, is a kind of insurance. The greater the perceived risk of default, the higher the CDS price. Lately, the prices of European CDS are soaring – both on corporate debt and on government debt. And European CDS prices are not simply rising in absolute terms, but also in relation to CDS prices of comparable credits in America and elsewhere.
Try to stay with us here…
The chart below compares an index of CDS prices on 125 large European corporations with an index of CDS prices on 125 large American corporations. (When the chart is red, US CDS are more expensive than European CDS. When the chart is green, European CDS are more expensive).
Three years ago, during the crisis of 2008, American CDS were more expensive than European, meaning the market considered American corporations to be riskier credits than European ones. Today, the pricing relationship has reversed completely. European CDS are more expensive than American CDS.
This trend is not entirely surprising, given the serious fiscal crisis that is unfolding around the periphery of the euro zone. The following chart, by contrast, is something of a shock.
The price of a CDS on 5-year French government bond, which is rated AAA, is much higher than the price of a CDS on a 5-year Chilean government bond, which is only rated A+. In other words, the CDS market is saying Chile is a much better credit risk than France.
Does the CDS market know something that all those smart guys at the credit rating agencies don’t know? Does the CDS market suspect that the “strong economies” of the West are not as strong as their reputations would suggest? Does the CDS market see that the global financial hierarchy we have today will not be the same hierarchy we will have tomorrow?
The world economy is changing right before our eyes, dear reader. Don’t let it change without you.
In today’s edition of the Daily Reckoning, guest columnists, John Mauldin and Frederick Sheehan, share two troubling vignettes from the real world that illustrate how the global financial hierarchy may be shifting already…