Timeliness remains a challenge in writing a monthly investment column. Markets change with lightning speed, rendering yesterday’s news very stale. Since May of this year, financial markets have undergone two paroxysms, leading to swift declines in asset prices. Both reverberated worldwide; both resulted from outside events. The first panic ended in mid-June. The outcome of the second is in doubt as this column is being written.
The two events had quite different causes and have two different messages for investors. Understanding these messages can help make us better investors.
The May meltdown
Let’s look first at the downdraft that began in May and lasted five weeks. On May 10, Federal Reserve officials released a statement indicating they had become increasingly concerned about inflation and that they would likely continue to raise short-term interest rates. Investors rushed for the exits like theater patrons hearing the dreaded word “fire.” Over the ensuing five weeks, the S&P 500 and the Dow both dropped about 8 percent.
What began as a hasty retreat from United States stocks turned into a rout in international markets. European stocks dropped 13 percent, Korea, Japan and China all lost more than 20 percent, the Russian market shed 29 percent and Brazilian stocks outdid them all, giving up a full third of their value in just five weeks. Even the price of gold dropped 23 percent over the same period.
Markets stabilized some by mid-June, softening the blow at least for large cap U.S. stocks. But during the five-week panic, the Dow and the S&P 500 Index had both dropped about 8 percent while the Nasdaq dropped more than 11 percent. The much greater decline of the emerging market stocks compared to the United States stocks provides an important clue as to what transpired during the panic, a clue buttressed by the significant decline in the price of gold.
A year ago, now Fed chairman Ben Bernanke told us the world was “awash in dollars,” his explanation of why long-term interest rates remained low. Bernanke was using polite language for “excessive liquidity” burning holes in investors’ pockets.
One concomitant of excessive liquidity is excessive risk-taking. When money is cheap, prices of other assets, particularly high-risk assets, rise. Gold, emerging market stocks, speculative stocks and other volatile assets had been rising relentlessly over the past several years as the Federal Reserve and other central banks stoked the economic fires with easy money.
The paroxysm we saw in global equity and commodity markets starting on May 10 was the direct result of risk-happy investors realizing that the Fed and other central banks might really be shutting off the monetary spigot and that easy money, high-risk investment strategies might just get badly hurt. These risk-hungry investors all headed for the exits at the same time.
This first panic was a product of internal market behavior. As greed drives investors with plenty of cash to make ever riskier bets, fear causes many of them to suddenly decide not to be the last one left holding the bag. Like a school of fish that mysteriously changes directions as if choreographed, risk-hungry investors suddenly rush for the safety of Treasuries or cash.
The July jitters
By mid-June, investors generally concluded the sky wasn’t falling. Stock prices stabilized and recovered somewhat through month’s end and into the Independence Day holiday. But then another sharp downdraft began. This time, the principal catalyst was events in the Middle East that appeared to be spiraling out of control. Each day brought escalating violence between Israel and its tormentors, Hamas and Hezbollah, likely backed by Syria and Iran.
Again, stock prices dropped in almost every trading session. After seven trading days, the S&P 500 and the Dow were down between 3 and 4 percent while the more volatile Nasdaq was down 7 percent. Brazilian stocks declined too, but in contrast to the May event, only by 8 percent, barely more than the Nasdaq. In contrast, the price of gold climbed 5 percent over the same seven days.
The July panic was driven by the perception that wider war in the Middle East would not only drive oil prices much higher but also lead to shrinking economic activity and thus to much lower corporate profits, the mother’s milk of stocks. The July downturn resulted not from internal market dynamics but from the perceived impact of political instability on economic fundamentals.
How should we respond?
Investors who take only reasonable risks don’t need to fear the kind of panic that started in May. First, their portfolios will not be badly hurt because they have limited exposure to risky markets. Second, panics arising from internal market dynamics tend to be self-limiting in time and severity. At some point, when enough people have piled out of emerging market stocks (or whatever) and into Treasury bills, the panic sputters out. In a typical stock market correction, prices decline by no more than 10 percent. Such a downturn usually presents investors with a buying opportunity.
Fundamental panics, however, have no recognizable bottom. While investors may overreact to external events, there’s no way to judge how long or severe the external disruptions might be, and thus, there’s no way to predict their market impacts. Even investors who take only reasonable risks must be prepared to wait out troubled markets for months or even years. Fundamental panics can cause a drag on market prices for a substantial period after the underlying events have resolved themselves. It takes time for investors to be convinced it’s safe to reenter the markets.
It takes an optimist to be a successful equities investor. Over the past century, the world has endured rampant inflation, natural disasters, terrible wars and despotic governments by the fistful. Yet through all that, long-term investors in stocks have been handsomely rewarded for their patience.
This column is not intended as investment advice. You should consult your own adviser in determining whether to incorporate any of the opinions expressed here in your investment decisions.
