The Jolt Felt 'Round the World

The Daily Reckoning – Weekend Edition
March 3-4, 2007
Baltimore, Maryland
by Kate “Short Fuse” Incontrera


Finally. On Tuesday, something – albeit briefly – took the place of Anna Nicole coverage on MSNBC and CNN…

The Dow fell more than 500 points at one time during the day, the biggest drop since the markets reopened in the days following the 9/11 attacks.

As with most events in the market, there is no one clear-cut reason why the tumble occurred – just a collection of speculations. After all, no one ever said the markets act rationally.

You could look to the Far East for a clue: Tuesday saw the highest daily slump to smack the Chinese stock markets in ten years…and the rest of the global economy certainly felt the jolt.

China’s People Daily Online reports: “If the Chinese markets catch a cold, the major markets around the world will sneeze,” Teng Yin, an analyst with Everbright Securities, quipped.

“This is the first time that Chinese stock markets have affected global markets significantly, but it won’t be the last,” Teng said. “The reason is China’s growing economic power.”

Of course, this isn’t the only reason U.S. stocks had their worst week in four years. February’s revised U.S. Consumer Sentiment fell to 91.3 from the originally reported 93.9. Weak durable goods orders sent some ‘worrisome’ signals to the market. And, oh yes, Big Al dropped the big “R”: recession.

In “private” speeches on both Monday and Thursday, the former Fed chairman flexed his economic muscles and showed that he still has the power to move the markets simply by uttering the dreaded word.

“By the end of the year, there is a possibility, but not a probability, of the U.S. moving into a recession,” Mr. Greenspan was quoted as saying by Bloomberg News, which based its report on interviews with people who attended the CLSA Japan Forum in Tokyo, where Greenspan was speaking.

However, the New York Times points out: “To be clear: Mr. Greenspan did not, as some analysts incorrectly inferred, predict that a recession was imminent. In fact, he said few forecasters anticipated one. But he did caution that the United States appears to be at the end of an expansion and that such times usually bring with them the seeds of a recession.”

Of course, Bernanke disagrees – and probably feels a little perturbed by his predecessor’s continuing power over the markets. He, along with St. Louis Fedhead William Poole, asserts that there is NOT a recession in the future, perhaps just a bit of economic “slowdown”.

Most analysts don’t predict that the sky is falling, and – surprise! – neither do we here at The Daily Reckoning. After an eight month high for stocks, a correction is not only unsurprising, but also inevitable.

And to further ease your fears, take this to heart: On Friday, whilst eating lunch at our local favorite, Mick O’Shea’s, Anna Nicole coverage was back in full swing on all of the televisions in the bar. In fact, it was the only thing CNN reported on during our meal.

So clearly, all is right with the world.

Short Fuse
The Daily Reckoning

P.S. The definitive reason for the market tumble will probably never be revealed, but we do know this: this past week’s events show the markets vulnerability…and volatility. And as investors, that shouldn’t scare you away – why not put your money somewhere that feeds off of this volatility? Strategic Investment’s Dan Amoss is a pro at positioning his readers to profit – while everyone else is being cleaned out.

THIS WEEK in THE DAILY RECKONING: With stocks looking at its worst week in four years, we had a lot to report on this week. And don’t worry if you missed some of our coverage – we have all five issues catalogued for you, below…

Normal Markets     03/02/07
by Bill Bonner

“A ‘normal market’ is a lot like a ‘normal tornado’ – both can whip things up and tip over the outhouse. Our only hope is that we’re not in it when it does. Bill Bonner explains…”

Japanica!       03/01/07
by Dan Denning

“Bennifer. Brangelina. TomKat. If the global asset boom were a celebrity marriage, what would we call it? Chimerican? Americhinan? Or how about…Japanica! Dan Denning looks at the events of the past week and aims to answer the question: is the whole current global asset boom model in jeopardy? Read on…”

Money Matters That Matter to Money   02/28/07
by Bill Bonner

“As yesterday’s events show, money is like a perpetual child. It needs to be cared for and worried about; otherwise it can get out of control. This week, Bill Bonner reminds us of a time when people still worried about things like trade deficits and money supplies, and how a current carefree attitude toward these things might lead to our downfall. Read on…”

A Bad Hand for Bernanke     02/27/07
by Adrian Ash

“It’s clear Bernanke’s been dealt a bad hand by the Maestro. But will the gold market fold, raise, or call his bluff…? Our U.K correspondent, Adrian Ash, explores…”

Gold’s Eternal Truth      02/26/07
by The Mogambo Guru

“This week, the Mighty Mogambo tries to convince his gathered audience that owning gold is the only way to save yourself from bubbles and a falling dollar. Well, gold and the Mogambo Time-Sharing Investment Scam (MTSIS). Read on…”

FLOTSAM AND JETSAM: Shanghai down 8.8%, London down 2.3%, the Dow down 3.3%. And so far, the ASX down by 3.5%. Is this the crash for which we’ve been flying a flag for weeks now? According to The Daily Reckoning Australia’s Dan Denning, the answer is a resounding no. Read on…

A Crash – Or Just a Collision?
by Dan Denning

The events of this past week is what you get when global markets go up for nearly eight months without a significant pull-back. It’s more of a collision than a crash, the kind of thing that happens when you go over a speed bump too quickly. You bang your bumper into the asphalt. It’s not so much that there were a lot of sellers this past Tuesday, but that there were a lot fewer buyers.

Not that we’d ever want to be accused of being bullish, but let’s keep things in perspective. The same Shanghai 300 Index that fell 9% had been up 23%, year to date. In the context of its rise the last three years, Tuesday’s collision was tiny. A real crash would be more like what happened to American sub-prime lender Novastar (NYSE: NFI). The company fell by 50% over three days when it reported rising defaults from its sub-prime borrowers. It also added, ominously (a ridiculous understatement) that it did not think it would make money any time in the next five years. Gulp.

Yet what is so different about paying too much money for a stock like Novastar and paying too much money for stocks as an asset class? In both cases the faulty assumption was the same: abundant liquidity would drive earnings and prices higher. With Novastar, it was higher interest rates that burst the bubble. With global stock markets, it was something else.

This brings us to the key vulnerability of the Goldilocks Paradigm: money supply, or liquidity. It takes a constantly increasing amount of money to drive stocks up. The same amount won’t do. Bubbles require more buying power, always more. That’s why liquidity theory is a better explanation of global stock price movements these days than valuation. Stocks long ago ceased to be correlated to real measures of value. With superannuation, private equity, and institutional buying, the ready supply of liquidity has been pretty smooth into all stocks-emerging markets and the Dow alike.

But not this past week. So just what happened? And where to from here? Probably more selling this week to shave another 5% off index values, followed-and we’re only guessing here-by a fresh run toward record highs in the North American spring. If we’re wrong, the crash to end all crashes will be this month. And though we think that day is coming, we don’t think it’s arrived just yet. Why?

Did you know that on any given day, just over 30% of the volume on the New York Stock Exchange comes from automatic, computer-generated buy and sell programs? The NYSE makes the data public on its website. We’ll quote some of it in a minute. But it’s important for a simple reason: the direction of global markets is determined a lot less by human beings and a lot more through program trading by computer programs, models, and algorithms.

The upside of this is that automated buying power pushes stocks higher. The downside is the Dow falls 200 points in two minutes as sell orders are automatically generated and executed. There’s not even time for some good old fashioned hand-wringing and sweaty brows. Computers don’t sweat. And they don’t panic. They just execute. “Sell.”

The NYSE keeps data on a weekly basis, so we can’t see quite what happened yesterday, at least not officially. But here’s what it said about last week, “During Feb. 12-16, program trading amounted to 32.1% percent of NYSE average daily volume of 2,962 million shares, or 952 million program shares traded per day… Program trading encompasses a wide range of portfolio-trading strategies involving the purchase or sale of a basket of at least 15 stocks with a total value of $1 million or more.”

For the week, just 15 separate firms trade over 4 billion shares using program trading. The NYSE classifies about 7% of these trades as “index arbitrage,” and the rest as “all other strategies.” So just what are those strategies? We don’t know, of course. But our guess is that some of them involve liquidating a position if the Dow falls, say 100, points.

You can see how the process of program-driven selling becomes self-fulfilling, each order triggering more selling, which triggers further orders. There are computer programs designed to prevent this, called “trading collars,” which apparently failed yesterday. At some point-probably later this week-other “buy programs” will kick in, and may in turn, trigger other “buy programs.”

Our point in all of this is that all rational discretion about what a business is really worth is thrown out the window. The index is driven by the programs, which then influences fund and ETF buying, none of which has anything to do with what a particular stock is worth. Buying and selling become reflexive, rather than reflective.

This is what we call speculation driven by liquidity. And ironically, it’s why recent history shows major one-day slides in financial markets seem to have little or no impact in the real economy. And it’s not just one-day slides either. Remember the tech-wreck? The Russian bond-default? LTCM? All of these mini financial panics took place in the stock market without, apparently, causing so much as a ripple in the real economy.

What happens in markets does matter, of course, and not least because it affects the net worth of consumers, who spend and earn money in the real economy. And in that sense, the stock market is a psychological leading indicator of the real economy. If investors are getting skittish-or become skittish because program trading causes a series of steep one-day declines-it can carry over into real world behavior.

God forbid most Western investors look at the real world. Then they’d really get scared, seeing millions of consumers in debt, with stagnant wages and large mortgage liabilities. Fully price that into the market and you’d start to see some real selling, as investor flee stocks into, of all things, short-term bonds with stable yields.

Hmm. Here’s a conspiratorial thought. Maybe all of this is an elaborate plot orchestrated by the GoldmanSachs/White House plunge protection team to drive global saving back into the U.S. bond market, just as the government needs to refinance its deficit and pay for its wars. Hmmn. Show of hands? Yea? Nay?

While you work that one out, we’ll make one additional observation that we made in the March issue of Outstanding Investments about gold stocks. In a collision/correction/liquidation, gold stocks will behave like stocks and not like the metal.

In a long-term bull market, the best entry points for the equity side of gold are after these corrections.

Your risk is that the metal itself outperforms the shares over the duration of the bull market. But if, as we believe, the big third leg up in gold is coming, the post-correction rubble will be the best time this year-and maybe for the next few years-to load up on gold senior and juniors. Ironically, the juniors may hold up under a correction better because there are fewer institutional owners (fewer weak hands with twitchy sell fingers to shake out.)

Dan Denning
The Daily Reckoning Australia

Editor’s Note: Dan Denning is the editor of The Daily Reckoning Australia. He’s also the author of 2005’s best-selling The Bull Hunter (John Wiley & Sons), and spent five years as editor of Strategic Investment, one of the most respected “big-picture” investment newsletters on the market. A former specialist in small-cap stocks, Dan draws on his network of global contacts from his new base in Melbourne, Australia.

The Daily Reckoning