The DJI drops 600 points, so where do we go from here?
Today, I watched the stock markets drop faster than a drunken fly. The tendency started in the Asian stock markets and the momentum carried that negative vibe across the planet. No market was immune. But looking at the reasons behind the huge equity lose today, only irrationality and fear of the unknown are the two main variables that explain such horrific day.
In my opinion, the market reaction is entirely disproportionate to what is happening in the world right now. It is certainly not because of the S&P downgrading the US government debt to a double-A+ rating (you have to remember that Moody’s and Fitch credit rating organizations still grant a triple-A rating to the US debt). Everyone knew prior to last Friday the state and the health of the US economy. It was not a surprise to anyone. And what is even more irrational is that if this drop is driven by the downgrade, why would we see the 10-year note down substantially since Friday? The same is also valid for the 30-year note, which is right now 3.68%. What that means is that it costs less money today (August 8th) for the US to borrow money over 10 and 30 years than it cost on Friday. The bond market (which is twice the size of the stock market internaitonally) is renewing its confidence in the ability of the US government and its economy. Most of the movements in the bond markets today are movements in favor of the US 10 and 30 year notes, which is basically a vote of confidence in the full faith and credit of the US. Clearly, the effects on borrowing have not been felt or have been ignored by the bond markets. Moreover, the stock market has always been more jittery than the bond market. It is composed of irrational jumpy investors and traders (and computerized trading that triggers sells or buys at a preset value), and the wild downward swing we are witnessing today (and probably tomorrow too) are not driven by serious bad economic data. Although the debt and deficit problems of the US are serious, they are not reflective of what we have seen today. The US debt and deficit problems are not structural, and can be solved easily–i.e., restructuring of the entitlement programs and an increase of revenues. Everyone knows the solution, despite of the political wrangling in Washington DC.
Furthermore, most of the economic data about the US is already out there–it is well known and the market has already digested it. So, the question that needs to be asked is what is the origin of this turmoil that took hold of the markets (worldwide) these days? Beyond the irrationality of the investors, i think that there are two major factors out there: 1) the huge debt problems in the eurozone; and 2) the probability that the eurozone crisis triggers another recessionary cycle or the so-called double-dip recession. The eurozone crisis is purely structural. We are witnessing an economic union that is not prepared to face such a crisis, and more importantly lacks the political and financial mechanisms to respond to a serious debt crisis of one or more of its members. The ECB, as monetary institution, is not doing its job. And to add insult to injury, no one seems to know the solution or the way out of this crisis that is gripping the EU right now. It was amateur hour during the Greek crisis (which is still ongoing and has not been solved), and then the contagion effect took hold and spread across the eurozone affecting Spain, Ireland, Portugal and Italy. Facing such a huge debt crisis in major EU members, the leaders and the institutions of the eurozone turnout to be incapable at crafting a lasting solution. What we are looking at are gimmicky solutions that have not reassured the market, and as long as there are not serious solutions and the ECB seems to be out of the picture, this eurozone crisis will worsen and will affect every country. The huge economic uncertainty that the eurozone debt crisis is causing will probably cause a major slowdown of the world economy–i.e., a recession. In my opinion, it is the fear of another looming recession that is causing the market to react this way.
We will probably see another sell-off tomorrow in every major market. And until investors feel that we have reach the bottom and bargain hunting begins, most major markets will be in a downward spiral. As for the bonds markets, i think they will keep on their positive trend in favor of the US treasury notes.