Market woes continue to plague investors

Uncertainty key issue in Wall Street

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Last week's market gyrations -- fueled by concerns about a possible double-dip recession, European debt problems and the U.S. credit rating downgrade -- are the latest links in a chain of woes that have haunted investors for a decade and changed the way they look at Wall Street.

Where to begin?

The tech bubble? Sept. 11? The credit crisis and the resulting Great Recession? The $17 billion that Bernie Madoff's investors lost? The S&P 500's lost decade? The flash crash of May 2010, when the Dow Jones Industrials plummeted 1,000 points in a matter of minutes? Galleon Group's Raj Rajaratnam's $50 million insider trading conviction?

No wonder investors, faced with continued prospects of chronically high unemployment and talk about cutting Social Security and other safety nets, are scared and suspicious. Standard & Poor's controversial downgrade of the federal government's credit rating and the Federal Reserve's conclusion that the anemic economy may need two more years of low interest rates compounded those fears.

"That news has taken more investors closer to the reality of where America is headed," said Thomas Nist of Duquesne University's business school. "More people are starting to pay attention to what's behind this and they're saying, 'Oh my gosh!' "

"We are losing altitude when it comes to certainty," he added.

Consider what Jeremy Grantham, chief investment strategist for $106 billion money manager GMO, wrote to clients recently: "My worst fears about the potential loss of confidence in our leaders, institutions and 'capitalism itself' are being realized."

Last week's manic market swings reflect the uncertainty clouding investor psychology.

After falling 513 points Aug. 4, the widely watched Dow Jones Industrial Average tumbled 635 points Monday, soared 430 points Tuesday, slid 520 points Wednesday, rebounded 423 points Thursday before finishing Friday at 11,269.02, down 176, or 1.5 percent, for the week.

"I expect the markets will keep bouncing around for some time," said William Schulze, a behavioral economist at Cornell University.

Uncertainty over the economy and the political impasse over the budget deficit will continue trumping corporate earnings, a good story that Mr. Schulze said is not being reflected on Wall Street.

"If there weren't so much uncertainty, the Dow should be closer to 14,000," he said. "We can create a double-dip recession if people panic."

Market volatility -- inexplicable swings up as well as down -- have been a fact of life since 2008, when the failure of Bear Stearns and Lehman Brothers led to the credit crisis and intensified a recession economists say began the previous December.

On a point basis, 14 of the Dow's 20 largest one-day losses and 14 of its largest one-day gains have occurred since Sept. 15, 2008, the day Lehman filed for bankruptcy. Last Tuesday and Thursday account for two of the biggest one-day gains over that period, while three of those biggest one-day losses occurred this month.

More thoughtful observers point out that, on a percentage basis, none of the Dow's 20 largest gains or losses came this month. On a percentage basis, the Dow's largest one-day plunge occurred in October 1978: a 508-point plummet that represented a 23 percent one-day decline.

Steeper one-day losses and gains were recorded more frequently in 1929 and the 1930s, as the market endured the Great Depression. However, the 1930s produced better returns for investors than the first decade of this century, said Geoffrey Gerber of Twin Capital Management in McMurray. He believes many investors should adjust their expectations of what they will make in the stock market.

Volatility and the prospect of lower returns are not only things that makes investors wary.

Some are concerned about sophisticated professional investors equipped with powerful computers, sophisticated algorithms and instantaneous data on price differences in global, 24-hour markets. The investors -- whether hedge funds, proprietary traders at investment banks or arbitrageurs -- capitalize on those price differences without regard to the fundamentals of the securities they are trading.

"These people are all being driven by pure and simple short-term evaluations," said Jay Sukits, who teaches finance at the University of Pittsburgh. "When those values get out of whack, they either start buying very heavily or selling very heavily. It's really a computer-generated trading process.

"I don't think your average investor who has 500 shares at their Merrill Lynch account realizes how much influence these proprietary traders have on the market," Mr. Sukits said.

Bizarre market episodes like the Flash Crash don't happen "because you and I are trading," said J. Randall Woolridge, a Penn State finance professor. He said today's trading is dominated by the sophisticated traders who try to capitalize on price swings among different securities.

"As long as the market's got volatility, they can make money," he said.

Their clout disillusions investors who were taught to buy and hold, particularly in light of the break-even returns of the past decade. Mr. Schulze believes that's why some investors worry that investing is akin to "taking all of our retirement money and betting it in Las Vegas."

The fear permeating the market is undeniable.

Mr. Schulze believes S&P's downgrade of U.S. debt was not justified, saying there was little chance of the federal government defaulting on its obligations. However, the events that triggered the downgrade -- the rancorous partisan bickering that preceded lifting the debt ceiling -- unnerved investors.

"It's important to realize the political climate is scaring everybody, not just S&P," he said.

Equally unnerving was the upsurge in demand for U.S. Treasuries following the downgrade. That reflects that the rating is not important to some investors and that others believe it will lead to downgrading other types of debt, including the debt of other countries currently rated AAA. If that happens, U.S. Treasuries could still be perceived to be the safest haven no matter what S&P says.

"How often do you have so much demand for securities that get downgraded?" Mr. Gerber said. "It suggests there may be problems elsewhere, which is how I think the market interpreted it."

If there is any optimism, it is that the fundamentals are not as bad as the computer-driven traders make them out to be. That is hard for many investors to fathom, given the 24-hour news cycle that many say exacerbates fears.

"These stocks are moving much more than any reasonable change in valuation would warrant. That makes investors nervous," Mr. Gerber said.

Mr. Sukits said if anything, recent economic news has been encouraging, citing the latest government data on unemployment, initial jobless claims and retail sales.

"I don't know what's different about the fundamentals of the U.S. economy today from a month ago," he said.

"What changes is you've got a lot of panic selling. They pulled the trigger fast and they pulled it in a big, big way."

It is the implications of those swift, automated market-jarring trades that give some market observers pause.

"That's a game changer," said Mr. Nist. "Market response is in real time. It can be programmed and that can lead to more programmed response."

Len Boselovic: or 412-263-1941.


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