Financial Turmoil - The Crash

Turmoil Continues
Even though Congress authorized a massive $700 billion capital infusion to restore liquidity to troubled credit markets, major stock indices around the world have fallen dramatically over the past two weeks. CNBC has a detailed chronology of how events unfolded this week. On Monday, October 6, the Dow Jones closed below 10,000 for the first time since 2004. The slide continued on Tuesday when the index lost more than 5% of its remaining value.

This prompted coordinated action on the part of the global financial community. Many central banks all cut their “benchmark” interest rates; the Federal Reserve announced an emergency 0.50% rate cute but markets still dropped sharply. Bad news continued on Thursday when General Motors stock sank to its lowest level in 60 years. The Dow closed the week at 8,451, wiping out nearly a decade of increased value.

The Crash
As the chart to the left shows, the Dow made steady progress since 1998 despite the technology crash, terrorist attacks, and lending downturns. As the economy appeared to improve after the events of September 11, the Dow Jones increased in kind. Last October 9th, the index reached a record high of 14,164. However, the recent stream of negative information concerning mortgage-backed securities and credit default swaps left the market vulnerable to a large sell-off, as seen to the right.

Even as Congress passed sweeping bailout legislation, the market plummeted. This decline was coupled with a sharp decline in oil prices to $80.80 per barrel, less than half of the record highs seen this summer. This decline is a bet that global recession will curtail demand. The sell-off wasn’t limited to just the United States. Global indices from Asia and Europe also suffered tremendous losses. The FTSE fell more than 8% on Friday, as did the DAX and CAC 40.

Reaching Bottom
The question on the minds of the investing public is whether the market has finally reached capitulation or will continue downward. The G7 nations are meeting to discuss a coordinated response to the crisis, but some feel it is too little, too late. Some signs point to a market bottom. Trading volume steadily increased over the past week and reached a high on Friday. Many analysts believe that trading volume peaks are a proxy for capitulation. Similarly, short-term Treasury yields approached zero on October 10^th, as the chart to the left shows. Over nine days, the one-month yield fell fifty-nine basis points to 0.07. Longer-term Treasury yields remained steady in the 4.00’s.

The exodus of money from the stock market has to find a home somewhere, and Treasuries are the safest investments available. The one month note is particularly attractive – it is as close to a risk-free investment available in the market. The rush of money into Treasuries has pushed yields to miniscule levels (see chart to the right). This indicates an unprecedented level of fear in the markets. Investors, both institutional and retail, have lost confidence in stocks and the banking system in general.

Outlook
This past week’s crash represents the painful results as companies unwind their unsound investments. Additionally, many wonder about the long-term efficacy of government bailout efforts. Legendary investor Jim Rogers postulates that the United States is headed toward a path of hyper-inflation:

The way to solve this problem is to let people go bankrupt. Then you will hit bottom and then you start over. The people who are sound will take over the assets from the people who aren’t sound and we will start over. This is the way the world has worked for a few thousand years… We’re setting the stage for when we come out of this of a massive inflation holocaust… We had the worst excesses we had in credit markets in world history. We’re going to have to take some pain. Many people bought 4-5 houses with no money down and no job… you think we’ll just say well, that’s too bad, we’ll start over and nobody loses their job? Be realistic.

When asked about the pending G7 meetings, Rogers responded with similar thoughts:

What they [G7 leaders] need to do is go down the bar and leave the rest of us alone. What about all the people in countries that minded their manners, saved their money, didn’t get overextended and now all of a sudden they’re being asked to bail out a bunch of guys on Wall Street who were incompetent at best and some of them crooks?

Mr. Roger’s views sound Darwinian, but they contain a certain common-sense appeal. The simple fact is that much of the rise in stock value since September 11 was artificial. It was a product of easy credit, lax standards, and arcane financial instruments. It was an illusory period where people believed they were wealthier than they actually were. Now, the illusion has faded away, and the markets must readjust to reality. A government bailout might smooth this cycle somewhat by helping liquidity. However, pain for global economy was and is inevitable. Bad, levered investments must be unwound; losses must be taken. The process of realigning markets to reality will require the failures of banks, companies, and investment funds.

In my next entry, I will discuss the options for investors going forward.