Why Markets Are So Shaky

Sept. 17, 2007 issue - Since mid-July, equity and fixed-income markets across the world have endured sickening declines and startling volatility. Major financial institutions have suffered grievous wounds, and numerous lesser bodies have drifted to the surface belly-up. On Aug. 28, a beautiful, relatively rumorless, late summer day, the Dow Jones Industrial Average abruptly collapsed 280 points, with the volume in falling stocks 10 times that of rising shares. Most of this rout came in the last two hours of trading. The next day there was a massive surge up of 247 points, again concentrated in the final hours. And so it has gone. The number of extreme days in the last six weeks is unprecedented, begging an explanation.

First, volatility breeds fear and therefore more volatility. The giant hedge funds and proprietary trading desks are run by people who, like us, are susceptible to fear and greed. Most are not particularly intellectual, analytical or studious. They rely on their intuitions, and their basic instinct is to buy when prices are rising and sell when they are falling. This is called "trend following" or momentum investing. Most computer-driven trading models are similarly programmed. In other words, selling begets more selling and vice versa.

Furthermore, the executives these hyperactive souls work for are very intolerant of losses—drawdowns, in the lingo of the business. The clients of the hedge funds, particularly the funds of hedge funds, will yank their money if a fund has a couple of months of 3 to 4 percent declines in net asset value. The risk managers who run the trading desks at the big investment banks and brokers are even more trigger-happy. If a proprietary trader gets down 10 percent, he is likely to be closed down.

Conversely, when a decline abruptly changes into a rally, traders who sold into the decline are scared to death that they will miss the chance to make back their losses. A buying panic develops. This frenetic activity is rationalized by the participants' murmuring "the market acts well" when it's going up and that "it acts badly" when the beast is falling. Mutual-fund and pension managers are less frenetic but they also are under pressure to outperform their benchmarks. While holding cash is a sure benchmark beater in a down market, it is a millstone heavy burden in a rally.

There also is a huge amount of hedging going on using the S&P 500 Index and other indexes. When the subprime mortgage crisis first began, selling from fixed-income hedge funds and other bond funds scared the stock market and created weakness in stocks. Much of the paper held by those fixed-income portfolios is illiquid—that is, hard to find buyers for. So in order to hedge falling fixed income positions, the fund managers sold the major equity indexes short. Thus, bad news for the mortgage and high yield markets caused weakness in stocks. Recently this relationship has reversed and the fixed-income markets are taking their cues from the stock market.

I wrote a column in this space a few months ago forecasting craziness like the crash of 1987, but I thought it was likely to be later rather than sooner. Unfortunately, being late is the same as being wrong. It is probably good that we got this bust out of the way now, and it is certainly healthy that the mortgage-high yield debt bubble has been pricked.

History suggests house prices in the United States will gradually fall another 5 to 10 percent and then remain soggy for years. Consumer spending will be seriously affected by the decline in house prices, and the U.S. economy will slow in the quarters to come but not slip into a recession. Any homeowner rescue package will be enormously expensive, quite inflationary and therefore unfriendly to bonds and the dollar.

However, the big capitalization, U.S. multinational companies that earn half of their profits abroad are still as cheap, relative to everything else, as they have been in 80 years. The world economy is healthy. Developing economies are booming, and account for almost 30 percent of world GDP. The economies of China and India are expanding at around 10 percent per year. On the other hand, slower U.S. growth is probably good because it suggests inflation will not be a problem.

My advice to ordinary investors: do the exact opposite of what the lunatics in the asylum are doing. Don't worry about the gyrations. They are almost impossible to time and trade. Decide whether you think stocks are good, long-term investments in this world (which I do) and, if so, continue to own individual companies that you know and appear reasonably valued, or hold index funds that mirror your convictions. There are specialized funds to fulfill almost every conceivable alternative; they are highly liquid, and their fees are minuscule. Exchange-traded funds (ETFs) have similar characteristics and can be instantly bought and sold (albeit with higher fees). In a world such as this, own the big global companies and emerging market funds.

Biggs, the famed Wall Street strategist, is now a hedge-fund manager at Traxis Partners.

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