Week 32: Wild Ride on Wall Street

August 13, 2011 – Week 32 presented historical volatility that no one in the market has seen before.  In the first four days of trading the Dow Jones Industrial Average (DJIA) moved up, or down, by over 400 points – the first time in the index’s 115 year history.  To put things in perspective, during this week investors saw over 2,000 points of movement in the DJIA which amounts to  20% of the current value of the index and yet, by the end of the week, the change in the DJIA and the other two major indexes (see below) were minor compared to the level of volatility that was experienced during this week’s trading as the market saw 3-4% gains, or losses.

In previous weeks we covered the VIX (the Volatility Index), which is often used by traders as a gauge of the markets’ volatility.  The greater the number of the VIX, the greater the volatility.   In the months of May, June and July, the VIX hovered around 20 – indicating very little volatility in the market.  But this week the VIX was over 46!

However, this reflection on what occurred with the markets really doesn’t answer why we saw the market in such turmoil.  Part of the answer lies in what occurred last week with Congress.  The sheer irresponsibility of extremist conservatives claiming that a default might occur, since they would not support raising the debt ceiling, was not good negotiating but rather, a message to the markets of just how risky the United States has become for investors.  When one thinks of holding a bond backed by the full faith and credit of the U.S. government, it means that no matter what may occur, our government will honor its debts.  It is risk free.  It certainly was not meant to be that a minority of those elected could use this obligation as a bargaining chip to push their own agendas.

Yet, in the infantile antics of those in Washington, they failed to realize that if government officials were to imply that the full faith and credit was now subject to one party’s political position,  the consequences could be  a dent in the nation’s perceived credibility as well as  our future ability to honor our debts.  Sure, this budget squeaked by, but what about the next time?  Are some Americans so naive that they think stiffing the rest of the world will turn out well or am I the only one who saw China’s brand new aircraft carrier on the front page of the Wall Street Journal?

And so it is time for the adults to enter Washington and remind everyone that the United States has prospered not due to its extremism, but rather, due to its ability to be the melting pot, the nation that tolerates differences and agrees to find solutions through compromise.  And while the current budget was approved, the damage had already been done – with the result being the credit rating of the United States was lowered for the first time in history!  Such news certainly would make foreign investors squeamish. Why would any foreign investor hold bonds of another nation that might one day opt not to pay?  Can anyone blame foreign investors for balking at buying or opting to sell U.S. investments in favor of those from more secure nations, like Singapore, Austria, Hong Kong, the U.K. and the Netherlands – all with AAA ratings.

The second shoe to drop this week came with a series of conflicting economic news.  At the forefront of these stories came as a surprise on Tuesday when Federal Reserve chairman, Ben Bernanke, gave investors a mixed message by saying that the Fed plans on keeping interest rates near zero for the next two years (yes, two years!), due to what the Federal Reserve perceives as a “weak economy” going into the future – and a sign that it does not see the economy recovering anytime soon.  Bernanke added that while the Fed plans on keeping interest rates low, it would be willing to take additional measures to stimulate things – in other words, find ways to help the economy grow.  The 2:15 EST message caused the DJIA to drop over 200 points, but then it rebounded  over 500 points in the last hour of trading as investors felt that any policies implemented by the Fed would result in the economy avoiding any return to a recession.  (This is often referred to as a double-dip recession).  On Tuesday alone, the DJIA swung over 700 points – leaving any investor flummoxed.

Such volatility in the market is a clear indication that investors are very unsure about the future.  While such volatility is disconcerting, it is not uncommon and is the reason why there are always buyers and sellers.  There are those that feel the market will grow, called Bull, and also those that feel that the market will not do so well, called Bears.  On any given day the battle between those that are bullish on the market and those that are bearish gets played out.  With the host of tools at investors’ discretion, there can be times that one group can cause some volatile trading.  When this occurs the VIX can reach over 40 as we saw this week.

Adding to the volatility is the ability for investors to buy and sell stocks quickly at ever increasing speeds.  The result is that there are traders that do not buy or sell stock on fundamentals (how strong a particular company is or may be in the future), but rather on market movement.  The most extreme example of this are the high-frequency traders (HFT’s) – these are not actual humans, but computers that operate on mathematical models by trading thousands, if not millions, of shares in seconds, hoping to make a fraction of a cent on each transaction.

Another group adding to the volatility are hedge funds that use derivatives that enable them to buy the right to purchase a stock in the future, or sell it now, even though they do not own the shares.  These are called calls and puts.  As you can imagine, these types of traders are playing the movement in the market and any news – good or bad, is the fuel they need.  Needless to say, one would not need to be an anchorman to realize that this past week provided ample ammunition for traders to try to move the market using these tools.

Yet, to predict the markets’ movement this past week would have required skills beyond earthly measure.  The failure to be accurate could have caused quite a lot of pain.  And for those that did get it right, one would have to wonder if they were more lucky than talented.  (In the next few weeks we will learn about these investors as the gains and losses will be reported.  Look for the guy that predicted oil would drop!)

While stock prices were all over the place this week, the fundamentals of most companies remained pretty much the same.  So some investors simply did nothing and waited for the dust to settle.  Others saw shares of companies they liked at lower prices and mostly likely gobbled them up.  It is not uncommon for traders to throw the baby out with the bathwater and a smart investor can take advantage of these moments by either adding to their position, or realizing not to join others in their folly of unloading equities of solid companies.  (Personally, at times I wonder if these wild swings are not some sort of orchestrated event to try to push down the shares of stocks, so that they can be swept up in the future – like a pool of dolphins herding a school of fish.  Not that I have any concrete evidence of this occurring, but when one sees such a herd mentality it seems plausible . . . at least to me.)

The story of this week could be lost looking only at the week’s percentage changes.  After all, a 1.5% change in the DOW is hardly newsworthy.  However, make no mistake.  Week 32 was anything but placid as investors got taken for a ride that few will forget and most likely will leave many fidgety for weeks to come.

 

Week 32 Market Data            
             
    Market Close                    % Change
  12/31/2010 8/5/2011 8/12/2011   Weekly YTD
             
DJIA 11,577.51 11,444.61 11,269.02   -1.5% -2.7%
S&P 500 1,257.87 1,199.38 1,178.81   -1.7% -6.3%
NASDAQ 2,652.87 2,532.41 2,507.98   -1.0% -5.5%
Crude Oil ($ per barrel) 91.4 87.08 85.3   -2.0% -6.7%
             
             
Sources: Thomson Reuters; WSJ Market Data Group