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The most common definition of a stock market "correction" is when the market declines by at least 10%. Situations like last week illustrate why common definitions can get a little tricky in practice.
Using the closing prices of the market indexes, we still have not had an official correction since the bull market began in March 2009. By that measure, the market fell just 8.4% in the recent weeks through last Thursday, May 6.
But if you use intra-day prices, from the high on April 23 to the low on Thursday, the market fell 12.6% — enough to qualify as an official correction. Given the unprecedented nature of last week's drop and the fear that accompanied it, I expect most investors will think of this as an official correction.
In recapping this "correction or not" situation, MarketWatch editor Nick Godt points out some interesting parallels between the news/market action of the past week and that of September 2008–March 2009:
If it felt in recent weeks like we were thrown back in time somewhere between the collapse of Lehman Brothers in 2008, the credit market freeze and the deep global recession that followed, it wasn't just a bad dream.
Exactly what I was thinking (I should have written it faster!). Last week's rapidly building fear about "contagion" spreading from the Greek debt crisis, the partial seizing up of the debt markets and quickly following plunge in the stock market — all of it felt very similar to the period in September–October 2008.
Thankfully, it was relatively short-lived, in part because of Monday morning's announcement that Europe had agreed on their own version of "Le TARP" — a stimulus and debt-relief package equivalent to nearly $1 trillion. How in the world they are ever going to pay for that is beyond me, but it can't help but remind us of the U.S. government's response in March 2009 when we passed our own stimulus bill and the markets roared back to life.
Make no mistake, this is merely "kicking the can down the road," much like our own stimulus package. The hope is that an organic recovery can take hold that will allow these monstrous debt commitments to be repaid over time. Whether events will play out that way remains to be seen.
While the long-term implications of this approach is unknown, it's worth noting what the U.S. financial stimulus did to the investment markets. They took off and didn't look back for a year.
That's not to say it was the right thing to do — there are more important considerations than the short-term boosting of the financial markets, and I think most of us have serious reservations about the price to be paid for all this in the future. But for the present, as investors, it would probably be foolish to ignore the potential implications of this second gush of liquidity into the system. If there's anything we've learned from the past 10-15 years, it's how responsive financial assets have tended to be to monetary stimulus and liquidity.
Some are pessimistic about the immediate impact Europe's problems are going to have on the U.S. markets. But it seems to me that this is yet another round of ammunition for a "great next 12-18 months, then watch out" scenario. Time will tell.
As always, attend to your immediate priorities (debt, savings) and don't take more risk than necessary in pursuit of your investing goals. That's one bit of certain financial instruction we can offer in these "interesting times."
There aren't many convincing answers available at this point regarding what actually caused yesterday's mini-panic, but one thing is clear regarding yesterday's crazy day: there was some serious weird stuff going on. Here's a brief recap.
First, here are the lowlights of how it unfolded:
- 2:00 p.m., Dow was down 155 points
- 2:40 p.m., down 415 points
- 2:47 p.m., down 988 points
- 2:57 p.m., down 388 points
- 4:00 p.m., down 347 points
So what happened? Investigators are poring over the details today, I'm sure. Among the oddities uncovered so far, the Wall Street Journal reports:
Multiple stocks, ranging from Accenture PLC to Boston Beer Co., momentarily lost nearly 100% of their value, changing hands for just one penny. Exchange-traded funds, which are index funds that trade like stocks on exchanges, were also temporarily vaporized. The $9.5 billion iShares Russell 1000 Value Index Fund went from $59 to around 8 cents in the blink of an eye.
At least six stocks went to zero, and at least one (Sotheby's) went from around $30 to $100,000 momentarily. Some traders report seeing others experience this kind of crazy behavior.
Most of what I'm reading this morning indicates that an errant trade — I've seen a couple reports that one Proctor & Gamble trade was entered with a billion rather than the intended million — sent the computer algorithms into a spasm.
Computer trading is the only one way I can imagine how a giant ETF trading at $59 gets executed at 8 cents a share moments later. Automated algorithms account for a huge percentage of the daily volume in the markets, and that's not all bad — it's one of the forces responsible for typically narrowing the bid/ask spread to a single penny in recent years (many of you likely remember the old fractional system when 1/8 — 12.5 cents — was the narrowest spread available).
The only problem is computers don't have "common sense" to recognize something is totally out of whack in conditions like that seven-minute window yesterday. They just keep following their rules and driving things further and further out of whack.
Expect some serious questions to be asked about these systems and how to better protect the whole market system in the future. In a way, given that things didn't melt down into total chaos yesterday, it may have been a helpful wake up call that can strengthen the system for the future.
And frankly, as scary as it is to realize the system has flaws like these, it's comforting in a way that the cause of the meltdown was likely mechanical rather than a genuine fear-based selling panic. Mechanical flaws can be addressed more easily than market psychology.
I started working for Larry Burkett in 1990, about the time he was beginning work on a book called The Coming Economic Earthquake. Larry wasn't an economist. He was just an extraordinarily insightful, common-sense guy who had the uncanny ability to see around corners.
Although some criticized The Coming Economic Earthquake (I think unfairly) as alarmist and economically unsophisticated, Larry's point was simply this: a government that takes on obligations it can't pay for will eventually face a time of reckoning.
Today, who can deny that this is true? Just read the newspapers. Greece. Dubai. California.
I suppose what made The Coming Economic Earthquake controversial is that Larry argued that even the strongest nation with the largest economy — i.e., the United States of America — was not immune from the principle that too much debt and too many unfunded obligations will ultimately lead to financial upheaval.
If you remember the book, or recall hearing Larry talk about these issues on the radio, a speech delivered last week by Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, will seem eerily familiar.
Congressional Budget Office (CBO) projections have the federal debt reaching an unsustainable level of two to five times our total national income within the next 50 years, which leads us to an inescapable conclusion — U.S. fiscal policy must focus on reducing this debt buildup and its consequences....
[I]t strikes me that we have only three options. First...: We can knock on the central bank’s door and request or demand that it "print" money to buy the swelling amounts of government debt. Second..: We can do nothing so long as domestic and foreign markets are willing to fund our borrowing needs at inevitably higher interest rates. Or third, the most difficult and probably the least palatable politically: We can act now to implement programs that reduce spending and increase revenues to a more sustainable level....
Throughout history, there are many examples of severe fiscal strains leading to major inflation. It seems inevitable that a government turns to [the first option; it calls on] its central bank to bridge budget shortfalls, with the result being too-rapid money creation and eventually, not immediately, high inflation....
German hyperinflation [in the 1920s] is one classic and often-cited example, and with good reason. When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a 500,000 Mark German note. He had been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house. In 1923, it would not even buy a loaf of bread. He said, "I want you to have this note as a reminder. Your duty is to protect the value of the currency." That note is framed and hanging in my office....
Many say it could never happen here in the U.S.... [But] the unthinkable becomes possible when the economy is under severe stress....
[T]he fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. If pre-emptive corrective action is not taken regarding the fiscal outlook, then the United States risks precipitating its own next crisis.
Back in early 1990s, some of our elected leaders read Larry's book and took heed. I know because I accompanied Larry on a trip to Washington (made at the invitation of a Congressman) where he spoke to many members of the U.S. House about the direction of the nation's finances. For a time, in the mid- to late-1990s, the situation improved. Spending increases were slowed and some of the national debt was retired.
Today, the government's economic picture is far worse than when Larry wrote the Earthquake book. Let's hope and pray that today's leaders will listen to Mr. Hoenig, and to the hundreds of thousands of citizens who are rising up to say, "Enough is enough."
The full text of Thomas Hoenig's address to the Peterson-Pew Commission on Budget Reform Policy Forum is here (PDF).
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