The Market: The painful ups and downs of the stock indexes over the last two weeks have left equity investors searching for explanations. Maybe it's time for a review of what causes such big swings.
We all know that electronic markets move stock prices with lightning speed, power and sometimes little regard for fundamentals. The Flash Crash of May 6, 2010, made this painfully clear. In recent sessions, the Volatility Index (VIX) reached the levels of the Flash Crash, but fell short of levels in the 2008-09 bear market. Still, the dent in public investors' psyches has been significant.
Investors also understand the recent gyrations have been tied to the debt-ceiling debate, the S&P credit downgrade, the sputtering domestic economy and the European economic train wreck. But understanding how these troubling developments cause movement in equity prices is another matter. In our global investment landscape, it's a complicated process indeed.
Markets have always been ruled by a herd mentality. Electronic markets and high-frequency traders not only move the herds more quickly but allow computer algorithms to trigger wave upon wave of sell orders, piggybacking on the decline without anyone there to say "enough." This often results in overextended short-term moves.
Such algorithms, or "programs," can be set to kick in automatically when indexes breach key support or resistance levels. This occurred repeatedly during the violent declines of recent days.
It's also important to understand how currency fluctuations influence equity prices. Global interconnectivity has created large markets that arbitrage one currency against another, usually based on differing interest rates in each country. This huge market in dollar terms is often referred to as "the carry trade."
Unfortunately, it's not a very liquid market. So when a violent swing in the dollar vs. other currencies occurs, the short side of the arbitrage must be unwound by raising cash from more liquid assets - most often stocks. Therefore, it's important for the savvy equity investor to be aware of effects of such currency gyrations.
Many other influences add to market volatility. But the basic lesson for equity investors is to remain focused on the near- and long-term variables that are the most potent drivers of prices.
Fundamental data such as earnings growth are a good place to start. Assessing the strength and weakness in the price and volume of individual stocks and the general market is another.
Electronic markets, the global investment landscape and short-term volatility are here to stay. A good night's sleep requires us to see through the foreground haze, embrace the reality and view the panorama beyond.
Read Full Article »
