Saturday, May 8, 2010

Bad Week for Wall Street

This past Thursday the Dow Jones Industrial Average experienced its largest intra-day decline since the stock market crash of 1987. The index fell nearly 1,000 points, nearly 10 percent, as about $1 trillion in market value briefly got wiped out.

By the end of the day, the loss was just under 347 points or 3.2 percent. What happened? According to media reports, it was all triggered by a trader entering a wrong number on a trade (billion instead of million).

This is what I was trying to warn investors about in last week's article!

Wall Street has become a casino with its entire focus on the very short-term. Each and every day, most of the stock trading volume (which has been dangerously very light for months) done on Wall Street comes from program trading and fast trading.

These are computerized programs designed to make many trades every day, making a little profit each time. The stock market has become susceptible to runaway feedback loops that swing prices and trigger buy and sell decisions automatically, with no human input.

These automated trading systems have nearly strangled the providers of liquidity in the past – the market makers and the specialists. When the stock market tanked in the past, these people would provide liquidity – that is, they would take the other side of the trade and buy stocks to support the market.

This is no longer happening, thanks to the robots and greedy Wall Street firms.

Stock Market Warning

However, US equity investors should not dismiss the mayhem in the markets as merely technical. It is also financially rational for the stock market to be jittery.

The Federal Reserve continues to hold interest rates at near zero. When interest rates are extremely low, the sensitivity of asset prices (including bonds) to a rise in interest rates is greatly amplified.

And interest rates have no where to go but up from zero. And sometimes they rise very quickly – just ask the banks which invested into Greek bonds.

There is also an overvaluation problem in US stocks. Stocks have skyrocketed in price on very little improvement in corporate earnings and in the US economy as a whole.

Long-term cyclically adjusted earnings multiples, adjusting for accounting changes, are off the charts in the United States. Stocks are not cheap. Caveat Emptor!

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