Showing posts with label volatility. Show all posts
Showing posts with label volatility. Show all posts
Wednesday, March 4, 2020
Donald Trump's Very Bad Day in the Stock Market
Today, March 4, President Trump had a very bad day in the stock market. Yesterday, Super Tuesday for the Presidential primaries, Joe Biden won a series of contests among the Democrats and took the lead in delegates over his principal rival, Bernie Sanders. Today, the Dow Jones Industrial Average rose almost 1,200 points in celebration.
Since before his inauguration, Trump has touted a buoyant stock market as one of the hallmarks of his Presidency. To him, it signaled approval, achievement and prosperity. Whenever the market showed signs of queasiness, Trump was quick to pummel the Federal Reserve Board for interest rate cuts to prop up stocks. Trump equated stocks with himself, and stocks seemed to reciprocate.
But not today. Today, the market loved Joe Biden. And Trump could only watch the love fest. The market no longer needs him. It can bounce up with Biden in the White House. The contest for the Democratic Presidential nomination is far from over. Biden's lead over Sanders is modest, with close to two-thirds of the delegates yet to be chosen. Many of the remaining primaries are in Western and Midwestern states, where the demographics may be more favorable to Sanders. But if Biden can maintain his momentum and secure the nomination, Trump won't be able to count on the stock market for support.
Saturday, August 30, 2014
The Next Market Bubble
Bulls and bears alike wonder when the next market bubble will emerge and pop. In recent years, major stock market downturns have come from bursting bubbles. Recessions, threats of war, terrorist attacks and other disturbances have caused market ripples. But the big gut wrenchers--the nosedives that wrecked your retirement--have come from the popping of asset bubbles. The gross over-valuation of tech stocks in 2000, the ridiculous real estate lending of 2005-07, those are the events that clobbered equities. What does the future portend?
Today, the mess in the Middle East grips our attention. Medieval atrocities by the Islamic State, a mosh pit with weapons in Gaza, mind-numbing slaughter in Syria and sectarian strife in Iraq appall and fascinate. But none of them will significantly drive down stock valuations. They just don't have the economic impact. The Ebola epidemic is now raging out of control in West Africa. But America's economic exposure to West Africa is miniscule. And the disease isn't likely to present a major threat to the industrialized world.
Is there an impending market bubble that could burst and dynamite the world's financial system? The answer is maybe, in Europe. The European economy is slowing. Growth is seen only on alternating Sundays. The EU stays afloat on a cushion of sovereign and bank debt--a lot of it. With Europe's slowing economy, it will be tough to pay down this debt and expedient to refinance by issuing even greater amounts of debt. Risks to larger members like Italy and France are rising. The EU is a financial and currency union without a unitary government. Thus, it is tailor made to borrow in bulk without governmental controls to interfere. We in America know from the 2007-08 mortgage crisis what happens when you bulk up on debt that can't be easily repaid. The vast amount of European debt presents potential systemic risk, just like the vast amount of American mortgage debt outstanding in 2007.
Exacerbating Europe's problems is the war between Ukraine and Russia. As Russia's direct involvement in combat is becoming increasingly clear, the war is likely to have ever greater impact on Europe. Sanctions by the West will probably be heightened, and Russia's retaliation will likely hit Europe harder than America. Europe's financial system could begin to totter as the EU is pushed into recession and capital flees the Old World. (Indeed, part of the buoyancy of U.S. stocks can be attributed to the arrival of capital now fleeing Europe.) A run on the Euro could be the straw that breaks the bubble's back.
The European Central Bank, as always, does a fan dance about how accommodative it will be. While it's become much more interventionist in the past couple of years, it remains constrained by its anti-inflation charter and the stolid, ever-frowning Germans. Maybe the ECB will save the day. Or maybe not.
Europe's economy, as a whole, is larger than America's. A tummy ache there could affect the rest of the world. if you're worried about where the next bursting asset bubble could come from, keep your eye on Europe.
Today, the mess in the Middle East grips our attention. Medieval atrocities by the Islamic State, a mosh pit with weapons in Gaza, mind-numbing slaughter in Syria and sectarian strife in Iraq appall and fascinate. But none of them will significantly drive down stock valuations. They just don't have the economic impact. The Ebola epidemic is now raging out of control in West Africa. But America's economic exposure to West Africa is miniscule. And the disease isn't likely to present a major threat to the industrialized world.
Is there an impending market bubble that could burst and dynamite the world's financial system? The answer is maybe, in Europe. The European economy is slowing. Growth is seen only on alternating Sundays. The EU stays afloat on a cushion of sovereign and bank debt--a lot of it. With Europe's slowing economy, it will be tough to pay down this debt and expedient to refinance by issuing even greater amounts of debt. Risks to larger members like Italy and France are rising. The EU is a financial and currency union without a unitary government. Thus, it is tailor made to borrow in bulk without governmental controls to interfere. We in America know from the 2007-08 mortgage crisis what happens when you bulk up on debt that can't be easily repaid. The vast amount of European debt presents potential systemic risk, just like the vast amount of American mortgage debt outstanding in 2007.
Exacerbating Europe's problems is the war between Ukraine and Russia. As Russia's direct involvement in combat is becoming increasingly clear, the war is likely to have ever greater impact on Europe. Sanctions by the West will probably be heightened, and Russia's retaliation will likely hit Europe harder than America. Europe's financial system could begin to totter as the EU is pushed into recession and capital flees the Old World. (Indeed, part of the buoyancy of U.S. stocks can be attributed to the arrival of capital now fleeing Europe.) A run on the Euro could be the straw that breaks the bubble's back.
The European Central Bank, as always, does a fan dance about how accommodative it will be. While it's become much more interventionist in the past couple of years, it remains constrained by its anti-inflation charter and the stolid, ever-frowning Germans. Maybe the ECB will save the day. Or maybe not.
Europe's economy, as a whole, is larger than America's. A tummy ache there could affect the rest of the world. if you're worried about where the next bursting asset bubble could come from, keep your eye on Europe.
Friday, April 13, 2012
The China GDP Head Fake?
Yesterday, April 12, 2012, rumors in the morning about China's first quarter GDP growth coming in around 9%, higher than the expected 8.4%, fueled a stock market rally. (See http://blogs.wsj.com/marketbeat/2012/04/12/stocks-jump-china-gdp-whisper-number-fuels-rally/). The Dow Jones Industrial Average bounded up 183 points.
Today, China's first quarter GDP growth was reported at 8.1%, lower than expectations by 0.3%. (See http://money.cnn.com/2012/04/12/news/economy/china-gdp/). The Dow closed down 136. The rumor was wrong, seriously wrong.
Maybe it was all an innocent mistake. After all, today's Friday the 13th. Maybe someone just misinterpreted something and spread the misinterpretation. But one thing's for sure. Some people made a bunch of money trading the market up yesterday, and then trading it down today. Volatility makes money for Wall Street pros, including market makers, specialists, high speed traders and so on. But some less cynical market participants, who bought and held overnight, probably lost money and quickly.
Volatility can come from exogenous sources. The idiocy underlying the EU's structural problems and its sovereign debt crisis weren't creations of Wall Street. But they sure as pumpernickel have caused a lot of volatility.
There's also home grown volatility, emanating from Wall Street sources that might have a good day at the office if the market is hopping. Spreading truthful and accurate news is generally okay, unless it happens within the context of insider trading. But spreading false information can make regulatory brows furrow.
It's difficult to investigate rumor mongering, especially if the rumor concerns aggregate economic data (as opposed to company-specific or security-specific information). But trading surges triggered by false information undermine investor confidence. Natural investors (i.e., those that buy with the hope of profiting from investing, as opposed to make a quick buck from trading) are the foundation of the financial markets. But, with the 2000 tech cash, the 2008 financial crisis, and the 2010 flash crash, they are leaning, if not running, toward the exits. It really doesn't help when they are jerked around by false rumors.
Today, China's first quarter GDP growth was reported at 8.1%, lower than expectations by 0.3%. (See http://money.cnn.com/2012/04/12/news/economy/china-gdp/). The Dow closed down 136. The rumor was wrong, seriously wrong.
Maybe it was all an innocent mistake. After all, today's Friday the 13th. Maybe someone just misinterpreted something and spread the misinterpretation. But one thing's for sure. Some people made a bunch of money trading the market up yesterday, and then trading it down today. Volatility makes money for Wall Street pros, including market makers, specialists, high speed traders and so on. But some less cynical market participants, who bought and held overnight, probably lost money and quickly.
Volatility can come from exogenous sources. The idiocy underlying the EU's structural problems and its sovereign debt crisis weren't creations of Wall Street. But they sure as pumpernickel have caused a lot of volatility.
There's also home grown volatility, emanating from Wall Street sources that might have a good day at the office if the market is hopping. Spreading truthful and accurate news is generally okay, unless it happens within the context of insider trading. But spreading false information can make regulatory brows furrow.
It's difficult to investigate rumor mongering, especially if the rumor concerns aggregate economic data (as opposed to company-specific or security-specific information). But trading surges triggered by false information undermine investor confidence. Natural investors (i.e., those that buy with the hope of profiting from investing, as opposed to make a quick buck from trading) are the foundation of the financial markets. But, with the 2000 tech cash, the 2008 financial crisis, and the 2010 flash crash, they are leaning, if not running, toward the exits. It really doesn't help when they are jerked around by false rumors.
Tuesday, January 5, 2010
Why 2010 Could Be a Tough Year for Wall Street
Most investors dislike volatility. When the market drops, stomachs churn. When the market rises, stomachs again churn if you missed the pop (as did many individual investors). If you bought on the way up, the ride is exhilarating--until it stops. And the damndest thing about markets is that they invariably stop rising at some point, and then fall.
On the other hand, Wall Street loves volatility. When stocks and bonds swing up and down, investors buy and sell them. That means commission income, and markups and markdowns, for brokers.
Volatility also provides trading opportunities, and the more volatility there is, the bigger the opportunity. The great housing collapse of 2007 gave hedge fund manager John Paulson the chance to make $15 billion for his investors, and over $3 billion personally. The next year, 2008, he reportedly made another $5 billion for his investors betting against big banks. His trading ability was crucial to spotting these opportunities. But the outsized volatility in housing prices and bank stocks enabled him to make gargantuan profits.
The big Wall Street banks often try to profit from volatility through proprietary trading--i.e., trading as principals. Goldman Sachs is famously skilled at this, and it's no accident that Lloyd Blankfein, Goldman's current CEO, came up through the ranks of the proprietary traders. Goldman has done well as a principal trading the ups and downs of the last three years.
Few prognosticators predict 2010 to be volatile. Most expectations for the economy range between modest growth to a double dip recession late in the year. Not many money managers are making glowing promises to their clients about the stock market, and the bond market seems murky more than anything else. Real estate may trend up slightly, or it may drop some more. No one really knows. Taken as a whole, the weight of current prognostications seems to indicate a muddled picture, with some asset classes moving up a bit and others down a bit. Assuming this to be true, Wall Street won't have the trading opportunities to hit the home runs of recent years. Hedge funds may struggle to stay ahead of the S&P 500. The big banks may have more modest returns than they did in 2009.
A year of pedestrian operating profits could prove tough for the big banks. They continue to hold many billions of hinky assets from the real estate crash, the credit crunch and the recession--CDOs, commercial real estate loans, defaulting credit card debt and so on. With the economic recovery slow, the banks will likely have to take more writedowns on these old lending mistakes. And there's always the risk of a new crisis in 2010. A major sovereign debt default (say, Greece or California) could dampen investor appetite for risk and highlight the virtues of holding cash.
Some believe commodities will be the big play in 2010. John Paulson and other money managers reportedly are betting on gold. But if the world's economies are truly recovering, they will pull up the fiat currencies against which the gold bulls are betting. And nobody expects a big jump in oil prices. One wonders if the recent reports of a brief cutoff by Russia of Belarus' supply might not have been someone in the Kremlin figuring on giving prices a little fillip.
If 2010 is a year without volatility, investors will breath easier. But Wall Street will probably make less money. With the ghosts of a lot of bad loans still haunting the Street, that could make it a tough year for the banks.
On the other hand, Wall Street loves volatility. When stocks and bonds swing up and down, investors buy and sell them. That means commission income, and markups and markdowns, for brokers.
Volatility also provides trading opportunities, and the more volatility there is, the bigger the opportunity. The great housing collapse of 2007 gave hedge fund manager John Paulson the chance to make $15 billion for his investors, and over $3 billion personally. The next year, 2008, he reportedly made another $5 billion for his investors betting against big banks. His trading ability was crucial to spotting these opportunities. But the outsized volatility in housing prices and bank stocks enabled him to make gargantuan profits.
The big Wall Street banks often try to profit from volatility through proprietary trading--i.e., trading as principals. Goldman Sachs is famously skilled at this, and it's no accident that Lloyd Blankfein, Goldman's current CEO, came up through the ranks of the proprietary traders. Goldman has done well as a principal trading the ups and downs of the last three years.
Few prognosticators predict 2010 to be volatile. Most expectations for the economy range between modest growth to a double dip recession late in the year. Not many money managers are making glowing promises to their clients about the stock market, and the bond market seems murky more than anything else. Real estate may trend up slightly, or it may drop some more. No one really knows. Taken as a whole, the weight of current prognostications seems to indicate a muddled picture, with some asset classes moving up a bit and others down a bit. Assuming this to be true, Wall Street won't have the trading opportunities to hit the home runs of recent years. Hedge funds may struggle to stay ahead of the S&P 500. The big banks may have more modest returns than they did in 2009.
A year of pedestrian operating profits could prove tough for the big banks. They continue to hold many billions of hinky assets from the real estate crash, the credit crunch and the recession--CDOs, commercial real estate loans, defaulting credit card debt and so on. With the economic recovery slow, the banks will likely have to take more writedowns on these old lending mistakes. And there's always the risk of a new crisis in 2010. A major sovereign debt default (say, Greece or California) could dampen investor appetite for risk and highlight the virtues of holding cash.
Some believe commodities will be the big play in 2010. John Paulson and other money managers reportedly are betting on gold. But if the world's economies are truly recovering, they will pull up the fiat currencies against which the gold bulls are betting. And nobody expects a big jump in oil prices. One wonders if the recent reports of a brief cutoff by Russia of Belarus' supply might not have been someone in the Kremlin figuring on giving prices a little fillip.
If 2010 is a year without volatility, investors will breath easier. But Wall Street will probably make less money. With the ghosts of a lot of bad loans still haunting the Street, that could make it a tough year for the banks.
Monday, November 3, 2008
Can the Federal Reserve Handle the Volatility?
As we discussed in our preceding blog, volatility in the stock market discourages investors. Buy and your investment suddenly drops in value. Place an order to purchase, and the market jumps before your order can be executed, causing you to pay more. With investment opportunities like these, you might prefer to sit in front of the TV, drink beer and eat potato chips. Better to pork out than take trading losses.
Volatility is also a macro-level problem. Two months ago, the Fed had to be cautious about lowering interest rates because of the high price of oil. The dollar was in the doldrums, adding to the inflationary pressure. Today, oil is regressing back to 2005 levels, and some low tax states may soon see gas under $2 a gallon. At the same time, the dollar has rebounded briskly against the Euro (although it's slumping against the yen). The Fed is now concerned with deflation--that rarely seen phenomenon where overall price levels fall. Deflation discourages consumption, because consumers wait for prices to drop before buying. Inventories pile up, manufacturing slows down and layoffs increase. Debt becomes more burdensome to repay, since borrowers must use more expensive dollars to pay their obligations.
In order to forestall deflation, the Fed lowered interest rates recently, a measure that is also meant to stimulate the recessionary economy. Monetary policy tends to take effect at a glacial pace. Interest rate changes often require 12 to 18 months to have a significant impact. Do we really think that oil prices will stay low for the next 12 to 18 months for the convenience of central banks around the world? Or is it possible that they may pop unexpectedly, as they did this past spring? Could the dollar slide again when investors get a fix on the size of future U.S. government deficits after the costs of all the bailouts and lending facilities becomes clear? The recent federal bailouts and interventions have, if anything, only increased America's status as the biggest spendthrift of all. This isn't good for the dollar.
Will the Fed be able to handle the unexpected volatility that we now know to expect? Will it be willing to change policies if a few months from now inflation, not deflation, turns out to be the problem? Events in the current financial crisis have moved very fast, and the government has been forced to improvise extemporaneously. At this point, its response consists essentially of just one measure: pumping as much liquidity into the financial system as fast as it possibly can. Methadone does work, in a manner of speaking. But it substitutes one addiction for another and the financial system is now addicted to government interventions and bailouts. The stock markets surged last week amidst a sequence of coordinated worldwide interest rate cuts. But you can't have a financial system that's all government all the time. The Soviets and Communist Chinese tried that idea and it didn't work out so well. One scary scenario is that the stock markets might soon bubble up on a cushion of government interventions and become disconnected from economic reality. The disconnect with reality has happened in the recent past--in the real estate, mortgage, and derivatives markets. Re-connecting was painful. Let's hope that the stock markets' current frothiness isn't irrationally exuberant.
All of the economic news from last week went from bad to worse. The nation's slide into recession may be sharper than the stock market expects. Layoffs are increasing quickly. Consumption is falling as people are actually saving. This is really weird. When Americans start saving, you know times are tough. The full picture may not have shown up in current official statistics, but it would basically take the appearance of the Yeti on people's front lawns to get red-blooded Americans to save. But they are, and that means, aside from confirmation of the existence of the Yeti, that we're probably in for a full-bore recession, the kind where parking enforcement officers find deep in their hearts the compassion to overlook illegally parked cars with people sleeping in them, close to where the soup kitchens are located.
Volatility is also a macro-level problem. Two months ago, the Fed had to be cautious about lowering interest rates because of the high price of oil. The dollar was in the doldrums, adding to the inflationary pressure. Today, oil is regressing back to 2005 levels, and some low tax states may soon see gas under $2 a gallon. At the same time, the dollar has rebounded briskly against the Euro (although it's slumping against the yen). The Fed is now concerned with deflation--that rarely seen phenomenon where overall price levels fall. Deflation discourages consumption, because consumers wait for prices to drop before buying. Inventories pile up, manufacturing slows down and layoffs increase. Debt becomes more burdensome to repay, since borrowers must use more expensive dollars to pay their obligations.
In order to forestall deflation, the Fed lowered interest rates recently, a measure that is also meant to stimulate the recessionary economy. Monetary policy tends to take effect at a glacial pace. Interest rate changes often require 12 to 18 months to have a significant impact. Do we really think that oil prices will stay low for the next 12 to 18 months for the convenience of central banks around the world? Or is it possible that they may pop unexpectedly, as they did this past spring? Could the dollar slide again when investors get a fix on the size of future U.S. government deficits after the costs of all the bailouts and lending facilities becomes clear? The recent federal bailouts and interventions have, if anything, only increased America's status as the biggest spendthrift of all. This isn't good for the dollar.
Will the Fed be able to handle the unexpected volatility that we now know to expect? Will it be willing to change policies if a few months from now inflation, not deflation, turns out to be the problem? Events in the current financial crisis have moved very fast, and the government has been forced to improvise extemporaneously. At this point, its response consists essentially of just one measure: pumping as much liquidity into the financial system as fast as it possibly can. Methadone does work, in a manner of speaking. But it substitutes one addiction for another and the financial system is now addicted to government interventions and bailouts. The stock markets surged last week amidst a sequence of coordinated worldwide interest rate cuts. But you can't have a financial system that's all government all the time. The Soviets and Communist Chinese tried that idea and it didn't work out so well. One scary scenario is that the stock markets might soon bubble up on a cushion of government interventions and become disconnected from economic reality. The disconnect with reality has happened in the recent past--in the real estate, mortgage, and derivatives markets. Re-connecting was painful. Let's hope that the stock markets' current frothiness isn't irrationally exuberant.
All of the economic news from last week went from bad to worse. The nation's slide into recession may be sharper than the stock market expects. Layoffs are increasing quickly. Consumption is falling as people are actually saving. This is really weird. When Americans start saving, you know times are tough. The full picture may not have shown up in current official statistics, but it would basically take the appearance of the Yeti on people's front lawns to get red-blooded Americans to save. But they are, and that means, aside from confirmation of the existence of the Yeti, that we're probably in for a full-bore recession, the kind where parking enforcement officers find deep in their hearts the compassion to overlook illegally parked cars with people sleeping in them, close to where the soup kitchens are located.
Thursday, October 30, 2008
Why Stock Market Jumps Discourage Investing
On Tuesday, Oct. 28, 2008, the stock market jumped about 11% in a single trading session. Good news, yes?
Well, not necessarily. Let's say you had been watching the market fall for most of the preceding week, and decided after the 300 point drop in the Dow Jones Industrial Average on Monday (Oct. 27) to start buying stocks. Your buy orders would have been executed in a rising market on Tuesday. If you have tried to buy mutual fund shares, you would have paid the closing prices for Tuesday (which could have been around 11% higher than the prices you saw Monday evening). The big jump on Tuesday might have been very costly. Most years don't provide investors with an 11% return. Anyone buying stocks or stock-based mutual funds on Tuesday could have "lost" more than a year's gain.
Everyone understands how downward volatility in the stock markets discourages investors. Upward volatility also contains traps. To some degree, you might be able to lessen this risk by buying ETFs, which can be purchased at intraday prices. But in a highly volatile market, getting an ETF order executed at the price you see one moment may be difficult if the market moves abruptly the next moment (which, these days, can easily happen). Consumers would be discouraged if the price of lettuce could rise between the time you took it down from the display case to the time you brought to the cash register. Stock investors can similarly be discouraged by a divergence between the prices they see and the prices they pay.
Much of the volatility may be attributable to big players trading the entire market, using program trading or comparable derivatives contracts. This kind of trading can run right over individual investors (see our blog at http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html). There's actually quite a bit of liquidity sitting on the sidelines right now. But the volatility of the market will encourage it to stay on the sidelines. That isn't good. Without a significant inflow of liquidity, the market cannot truly recover.
No federal intervention or bailout can directly reduce stock market volatility. The volatility is a product of the uncertainties about the financial system and the economy, and these uncertainties abound. Perhaps the various federal measures aimed at helping an ever-increasing array of institutions, companies and individuals will eventually lead to calmer markets. Then, again, perhaps the large amounts of still unrecognized losses from the mortgage crisis and the slowing of the world economy will keep the markets jumpy. Until things calm down, though, don't expect a true market recovery.
Well, not necessarily. Let's say you had been watching the market fall for most of the preceding week, and decided after the 300 point drop in the Dow Jones Industrial Average on Monday (Oct. 27) to start buying stocks. Your buy orders would have been executed in a rising market on Tuesday. If you have tried to buy mutual fund shares, you would have paid the closing prices for Tuesday (which could have been around 11% higher than the prices you saw Monday evening). The big jump on Tuesday might have been very costly. Most years don't provide investors with an 11% return. Anyone buying stocks or stock-based mutual funds on Tuesday could have "lost" more than a year's gain.
Everyone understands how downward volatility in the stock markets discourages investors. Upward volatility also contains traps. To some degree, you might be able to lessen this risk by buying ETFs, which can be purchased at intraday prices. But in a highly volatile market, getting an ETF order executed at the price you see one moment may be difficult if the market moves abruptly the next moment (which, these days, can easily happen). Consumers would be discouraged if the price of lettuce could rise between the time you took it down from the display case to the time you brought to the cash register. Stock investors can similarly be discouraged by a divergence between the prices they see and the prices they pay.
Much of the volatility may be attributable to big players trading the entire market, using program trading or comparable derivatives contracts. This kind of trading can run right over individual investors (see our blog at http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html). There's actually quite a bit of liquidity sitting on the sidelines right now. But the volatility of the market will encourage it to stay on the sidelines. That isn't good. Without a significant inflow of liquidity, the market cannot truly recover.
No federal intervention or bailout can directly reduce stock market volatility. The volatility is a product of the uncertainties about the financial system and the economy, and these uncertainties abound. Perhaps the various federal measures aimed at helping an ever-increasing array of institutions, companies and individuals will eventually lead to calmer markets. Then, again, perhaps the large amounts of still unrecognized losses from the mortgage crisis and the slowing of the world economy will keep the markets jumpy. Until things calm down, though, don't expect a true market recovery.
Tuesday, August 7, 2007
Stock Market Volatility and How It Bailed Out the Fed (This Time)
Anyone with even a passing interest in the stock markets has noticed the surge in volatility in recent months. The Dow Jones Industrial Average seems clinically manic-depressive, flying in the stratosphere one day and bungee jumping with a frayed rope the next day. Daily movements of 200 or even 300 points have become commonplace. Antacid manufacturers and therapists are celebrating.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.
Where does the volatility come from? There's no way of knowing all of the reasons. As discussed in an earlier blog, there are unknown factors that probably will never be known. http://blogger.uncleleosden.com/2007/07/why-stock-market-bounces-around.html. But not everything is unknown. Here are a few thoughts to chew on.
1. The Managed Money Problem. The greatest threat to professional money managers is the index fund. Most money managers can't beat the S&P 500, and many don't even do as well. If a money manager can't beat the S&P 500, why would his or her clients not simply move their money to an index fund? Many index funds have low fees and expenses, and are relatively tax efficient. Money managers feel the pressure to step away from traditional stock picking and try out other strategies in order to get even a tiny increment ahead of the overall market. For example, one can trade futures contracts for the S&P 500. This is a game for bigtime money managers and institutional investors. Individual investors should not try this at home. If a money manager senses that the stock market is likely to fall, he could sell S&P 500 futures contracts in an effort to hedge his stock holdings, or simply to bet on the price drop. Alternatively, he could buy S&P 500 put options, which would hedge his losses if the S&P 500 drops.
If the market begins to sink after the money manager has sold S&P 500 futures contracts or bought S&P 500 put options, the counterparty to that transaction will begin to sell the S&P 500 stocks to hedge its exposure (or do some sort of derivatives trade with another counterparty, who will start to sell stock). Either way, sell pressure is added to the market at a time when it is teetering. Financial history buffs will recall that portfolio insurance had a similar effect in the 1987 market crash.
2. Yen carry trade. Interest rates in Japan have been extremely low ever since the Tokyo stock markets rose in the 1980's and then crashed in 1989. The Nikkei 225 fell from an all-time high around 38,900 to the 7,000 to 8,000 level and has risen to around 17,000 today. The Japanese stock market bubble was accompanied by a real estate bubble so extreme that the Japanese imperial palace was said to be worth more than the entire value of all the real estate in America. Some Japanese home buyers took out 100-year mortgages (that's some inheritance for your kids). Needless to say, the Japanese real estate bubble also popped. Between the stock market crash and the real estate bubble popping, Japan's banks were saddled with such enormous loan losses that they very possibly were insolvent. In order to bail out the banks, the Japanese central bank lowered interest rates to virtually zero (which meant the banks could take deposits and otherwise borrow money for almost no cost). These rates have been kept more or less around zero until recently.
The extraordinarily low interest rates in Japan gave rise to a trading strategy called the "yen carry trade." You borrowed yen at the very low rates available in Japan, converted it into dollars, and invested in the U.S. Because U.S. interest rates and other returns were quite a bit higher than your borrowing costs, you made some easy money fairly quickly. There's nothing like easy money. Many Japanese have been using this strategy. So have many other investors, from places like the U.S., U.K., Australia and New Zealand. Anyone who can borrow yen--and in today's globalized financial system, that means almost anyone who can borrow--can do the yen carry trade.
The catch--remember, in all investment schemes, there's a catch--is that currency exchange rates fluctuate. If the dollar drops in value against the yen, the dollar denominated investment gains you get will be reduced by your losses in the dollar. In the last year or so, the dollar has been dropping against the yen. While the drop has been fairly gradual, it's been enough to make yen carry traders nervous.
Then, the stock market fell, sometimes abruptly, in the last two and a half weeks. That's been enough to make a lot of yen carry traders throw in the towel. They've ditched their U.S. investments, and reconverted their money into yen.
3. Hedge Funds. You knew hedge funds would be mentioned sooner or later, and here they are. Hedge funds that invested in subprime and other mortgages (another thing you knew would come up) have been receiving many withdrawal requests from nervous investors who believe too much of what they read in the newspapers. In the case of one Bear Stearns sponsored hedge fund, the fund simply ceased honoring withdrawal requests. But many other hedge funds have been trying to accommodate these nervous Nellies who have a complex about retiring with only Social Security.
The hedge funds have a minor problem, though. There aren't many people paying cash for CDOs these days. Some CDOs, when put up for auction, apparently aren't getting any bids at all. You can't honor a withdrawal request with zero. So, hedge funds have been liquidating other investments, like other debt securities. The private equity debt and junk bond markets have been particularly hard hit by these liquidations, and spreads between these securities and Treasuries have widened sharply. It's also likely that some of the selling in the stock markets has also been hedge funds raising cash to meet withdrawal requests, or just hoping to avoid losses.
4. Short Sellers. Short sellers are viewed by many as a scourge. They are disliked for profiting from misfortune and scorned for scavenging. However, they may assist the pricing function of the market, pushing the price toward its true equilibrium.
Some short sellers have no doubt been shorting the market (through derivatives that allow them to trade the equivalent of the S&P 500 or other broad market indexes). This probably has added to the downward pressure on the market. However, the shorts can also fuel some of the upward pops in the market. When the market begins to rise, the shorts start to take losses on their positions. As their losses increase, the counterparties with whom they traded (in order to assume their short positions) will often ask for cash collateral. If the shorts don't or can't provide cash collateral, or simply want to cut their losses, they'll buy stock to cover their shorts. This "short covering" is fast and intense, and may account for the laughing gas quality of some of the recent upswings in the market.
5. Derivatives Market? The increasingly tattered state of the derivatives market may account for some of the increased market volatility. There's no way to know for sure, since the derivatives market is unregulated and seriously opaque. But many players that might write derivatives contracts to protect holders of stocks from downswings could be inclined to demure these days. They may have taken losses in the subprime and corporate debt markets, and be unable to take on additional equity risk. They may simply be skittish, not knowing how bad things are, and prefer a quiet game of croquet.
Derivatives are said to moderate volatility by shifting risk to parties willing to take it. There's some truth to that. The problem is one of success--they proved so good at risk shifting that more players began investing in risky contracts, with expectation that they'd shift the risk to someone else. That was a clever strategy until it created such a large amount of risk that the mortgage market belly flopped. We discussed these unintended consequences in http://blogger.uncleleosden.com/2007/07/how-cdo-market-increased-subprime.html.
If some of the participants in the derivatives market have stopped playing in that particular sandbox, others seeking to hedge their stockholdings may be unable to lay off their downside equity risk. In that case, they'd have to take old fashioned action to protect themselves--like sell. As the derivatives market pulls back, it won't damp volatility as much.
There may be many other causes of market volatility, although these are probably enough for anyone who owns stock. The past few years have been unusually calm ones for the markets. But an unduly large amount of risk may have been heedlessly created because of the Panglossian perception fostered by that calm. The concern now is that this change in financial climate may have created the conditions for larger and more frequent hurricanes. Let's hope the levees hold.
A Fed Bailout: in the vein of cat-saves-people-from-fire stories, we noted in the preceding blog (http://blogger.uncleleosden.com/2007/08/uncle-alans-legacy-at-federal-reserve.html) that the stock market was hoping the Fed would give the market a little boost at its meeting today. In anticipation of some dispensation, the Dow rose 287 points on Monday (8/6/07), the day before the meeting. With a handicap like that, it was easy for the Fed not to indulge the market, hold interest rates steady and maintain that its primary concern is controlling inflation. The Fed gave the market a bit of a doggy treat by noting the problems in the credit and real estate markets, and the stock market's volatility. But it gave no real indication that an interest rate cut would be forthcoming at any predictable time in the foreseeable future. The Dow closed up 35, apparently satisfied with the crunchy chicken and beef flavor of its treat.
Animal News: you can't take hardly any liquids on board a plane, but if it's a monkey . . .
www.wtop.com/?nid=456&sid=1212487.
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