Thursday, May 6th the stock market began like most days. Since it hit the panic bottom in March, 2009, it steadily climbed each month with very little volatility. The 12-month period ending April 30th realized a 38%+ gain. However, recent market increases have been accompanied by worries of how several European countries are going to pay their debts….specifically Greece but also Spain, Portugal, Ireland and Italy. To deal with their debt problem, the Greek government outlined “austerity measures” to the Greek people. Essentially, Greek citizens were informed they were going to have to work more years and pay more taxes (it was more complicated but that was the bottom line). Greek citizens weren’t pleased and social unrest became live headline news.
On May 6th, we awoke to CNBC coverage of Greek riots. It was an inauspicious morning, with the Dow Jones Industrial Average opening down about 26 points from its closing price of 10,868 the previous day. After trading in a small range all morning, European financial problems began to worry investors and shortly after noon the Dow declined as much as 100 points. We have seen the Dow move up and/or down 100 points many times so this did not raise any eyebrows. However, the Dow continued its steady decline and, an hour later was down 200 points. It took another 24 minutes for the Dow to drop the next 100 points and, at 1:35, it was down over 300. Seven minutes later, down 400.
After that, the selling began picking up steam. Over the next 5 minutes, the Dow plummeted…..down 450, 500, 600, 700, 800, 900, and then, at 1:37 the Dow had declined almost 1,000 points to 9787.17. At that point, it began a steady climb to close at 10,520, ending down “only 348” for the day.
The day carried with it some odd trades. Accenture, which closed the previous day at around $42, traded as low as $.01. You read that correctly….Accenture traded for one penny per share. The buyer got a great deal and the seller was robbed. Procter & Gamble, which closed the previous day a little over $61, traded as low at $37….and back up to $60 the next day.
Some trades have been cancelled by the exchanges and the official low price for Accenture is now $17.74 (still a fair discount from $42). The official low price for Procter & Gamble was $39.37, down over 33% from the previous day.
So what happened? Why did the market plummet 1,000 points and regain over 600 points in one afternoon? Was it someone with a “fat finger” who accidently typed a “B” instead of an “M” (for a billion shares instead of a million shares)? Was it irresponsible short-sellers? The financial news networks quickly attempted to explain what happened but only came up with ridiculous scenarios. CNBC even called Procter & Gamble to ask them why their stock traded as low as $37. Procter & Gamble makes shampoo and diapers. They don’t know what makes stock prices go up and down.
What happened was “computers”.
In our never-ending thirst for speed, speed and more speed, we developed “electronic exchanges” (exchanges run strictly by computers with no human interaction). If you want to buy shares of a stock, sending your order directly to a computer immediately matches your order with an order to sell shares of the same stock…at the lowest possible price. This has provided investors with better prices and lower transaction costs.
I consulted an ex-colleague who has spent many years on Wall Street and has helped design and make rules for electronic trading systems. He explained that, although what happened could be attributed to the proliferation of electronic exchanges, the events of May 6th were more the result of “a perfect storm” and a little more complicated than just saying “computers happened”.
Before electronic exchanges, stocks that traded on the New York Stock Exchange traded ONLY on the NYSE. Stocks that traded on the American Stock Exchange traded ONLY on the AMEX. And stocks that traded on the NASDAQ traded ONLY on the NASDAQ. Electronic exchanges changed all that. So what had been a very centralized (but slow and inefficient) trading system became a very de-centralized and fragmented (but extremely fast and efficient) trading system.
The “perfect storm” occurred in the afternoon when, among other things, the fail-safe mechanisms designed to help ease problems at a couple of the exchanges, were triggered and those exchanges stopped receiving orders for a very short period of time. Orders that might normally be split between all the different exchanges got re-routed to a fewer number of exchanges. This caused a temporary (but devastating) liquidity problem at the exchanges which were receiving the orders and the “sell” orders quickly overwhelmed the “buy” orders and, as my former colleague says, “down the market went”. At some point the humans stepped in and decided to buy at the artificially low prices. Finding few willing sellers, the market began recovering and climbed over 600 points to finish the day down 348.
Regulators and exchanges have not announced how they plan to fix this problem. Nor have they announced how they plan to anticipate future problems and fix them before they become problems. Last month, I conceded that I understand why you might want to put your money into a mattress. The people running the regulatory bodies, the financial institutions and the exchanges are not instilling a tremendous amount of confidence in the average investor.
However, at Boyer & Corporon Wealth Management, we are investors, not traders. What occurred May 6th is of little concern to us except to the extent that we might be provided the opportunity to purchase a company at an exceptionally low price. We understand the dangers of the market trading systems and know how to navigate them.
Last month I attended the annual conference for financial analysts presented by the CFA Institute. The conference, which brings together some of the brightest financial minds, was held in Boston.
Seth Klarman of the Baupost Group was one of the keynote speakers. He observed that we have not seemed to have achieved the “value” out of this economic crisis that we should have. In contrast, the generation that grew up in the first half of the twentieth century developed a “depression mentality” because of the decade-long depression of the thirties. They learned frugality and prudence because many of them did without for so long. He said all we got out of this crisis was a “Really Bad Couple of Weeks” mentality. Let’s hope we don’t have to experience 25% unemployment and a decade-long depression to develop financial discipline.
Klarman said he is more worried about the world today than he has ever been in his career. Politicians find it easier to inflate and debase our currency than to tackle serious problems. Tackling serious problems does not win votes. This can result in serious consequences for the dollar. He referred to our economy as the “Hostess Twinkie” economy. In other words, very little about it is natural. Government stimulus is making things appear better but what happens when government stimulus ceases? We may not know for a while because the European stimulus may have postponed it.
Another speaker made an extremely compelling case that inflation and higher interest rates are not likely to occur for at least 3-4 years. The primary reasons he cited for continued low inflation are the unemployment/underemployment rate of 17% – 20% and total U.S. debt (public and private), which is 370% of GDP. One major component of inflation is labor costs. In an environment with high unemployment, most laborers are grateful to have a job and are not in a position to demand increased wages. Our level of total debt is the highest it has ever been (in 1933, debt peaked at 299% of GDP). As consumers and nations are forced to reduce debt rather than spend and consume, deflation is a bigger threat than inflation.
Ian Brennan from the Eurasia Group listed the Top 10 Risks of 2010:
- U.S. – China relations
- We will see significant deterioration in US-Chinese relations this year. China has been able to sell to the American consumer at artificially low prices because of their control over the value of the Chinese yuan.
- Increased protectionist policies by the U.S. along with slower U.S. consumer spending will increase tensions.
- Iran
- Biggest geopolitical risk of 2010
- Due to their nuclear program, Iran is facing tougher sanctions from the U.S., Europe and Japan.
- European fiscal divergence
- Greece, Ireland, Portugal, Spain and Italy face fiscal challenges (discussed in previous Monthly Commentaries).
- U.S. financial regulation
- The reform package which passed the House of Representatives will be moderated in the Senate but will still be more far-reaching than any financial reform since the Great Depression.
- Targets are systemic risk, derivatives regulation and the proper role of the Federal Reserve Bank.
- High likelihood the regulation will pass but the need to serve political interests will become more at odds with the need to create an efficient framework for regulatory reform.
- Japan
- The new Democratic Party of Japan (DPJ) efforts to limit influence of bureaucrats and industrialists creating higher policy risk.
- Some worry that the United States will replicate Japan’s lost decade. Others worry that Japan might be starting another lost decade.
- Climate Change
- Failure for countries to agree on a global climate change treaty in Copenhagen could have repercussions:
- A global climate change treaty is now likely to be years away, if ever.
- Natural gas markets emerge as a loser. Outside North America, implementation of a “carbon price” is necessary to encourage fuel switching. This now not likely to occur.
- Failure for countries to agree on a global climate change treaty in Copenhagen could have repercussions:
- Brazil
- Long-term economic outlook looks strong.
- 2010 could present a bumpy ride as Brazil is in an election year and will transfer power from Lula to a new leader….likely to be Lula’s hand-picked candidate, Dilma Rouseff.
- Much infrastructure work to be completed, particularly for the World Cup in 2014 and the Olympics in 2016.
- India-Pakistan
- For the first time in a decade, there are serious factors pushing the Indian and Pakistani governments back toward confrontation.
- Eastern Europe
- High levels of unemployment combined with elections in 2010 make several Eastern European nations unstable. Particularly Ukraine, Hungary and Latvia.
- Turkey
- Country risk is hitting Turkey from all sides.
- International orientation is moving away from Europe and toward Iran and Syria.
The general tone of the conference was that the U.S., as well as many European nations, is increasing debt at alarming proportions. At some point (the “tipping point”), it becomes nearly impossible to decrease the debt because too much of the annual revenues may be needed just to pay interest on the debt. It’s very much like many U.S. consumers who have accumulated a large amount of credit card debt. When they accumulate too much debt, all they can do is make the minimum monthly payments for the rest of their lives…or declare bankruptcy. We don’t know where that tipping point is. We don’t know how much debt is too much debt. But as Mr. Klarman pointed out, companies and countries go bankrupt gradually…and then suddenly.
Through the end of April, the Dow Jones Industrial Average was up 6.42% for 2010. However, after the 7.56% drop in May, it is now -1.63% for the year. This is after an entire decade where the annual return was just over 1% per year.
Lastly, if you read our Investment Commentary regularly, you know that we view housing statistics as an important barometer of the health of the U.S. economy. Nationally, there were 333,000 new foreclosure filings in April, down from 367,000 the previous month but the 14th consecutive month of over 300,000 new foreclosure filings. The total number of foreclosure filings for that 14-month period is over 4,710,000!
Anecdotally, I have been counting real estate “for sale” signs on my bicycle route through my neighborhood. I began counting in the summer of 2007.
Summer of 2007 7 signs
Summer of 2008 24 signs
Summer of 2009 26 signs
April of 2010 14 signs
May of 2010 16 signs
I’m watching to see if the trend continues to get better or if we just had a little shot in the arm from government tax credits for home buyers.
Boyer & Corporon Wealth Management continues to be cautious, although we have been carefully increasing our equity exposure on days when the market experiences dramatic declines. We are less worried about inflation and higher interest rates in the immediate future. Therefore you will see us slightly extending the duration of our fixed income investments.
This information is provided for general information purposes only and should not be construed as investment, tax, or legal advice. Past performance of any market results is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.