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Generational Dynamics Web Log for 10-Oct-2008
Stock market is in free fall, as forced selling accelerates

Web Log - October, 2008

Stock market is in free fall, as forced selling accelerates

A worldwide full scale panic may be in progress.

The last hour of trading on Wall Street on Thursday was close to a full scale panic.

Market summary, 9-Oct-2008

Market summary, 9-Oct-2008

At 3 pm, the Dow index was down 200 points.
At 3:30 pm, it was down 400 points.
At 4 pm, it was down 579 points.
At 4:07 pm, it was down 679 points.

Note that the market closed at 4 pm, but the post-closing final settlements brought the Dow down another hundred points in 7 just minutes on huge volume.

According to CNBC, the final rush was caused by forced selling by hedge funds and money market funds, because people are pulling their money out of these funds, and also forced selling by people required to meet margin calls (when they had acquired their stocks on credit).

At this writing, on Thursday evening ET, the Asian markets are falling sharply, as much as 5-12%.

Believe it or not, I still heard analysts today say that this is a GOOD thing. "The stock market is oversold by ABSOLUTELY HISTORIC proportions," said one. "You could see a thousand point pop any day now!" Another said, "This must finally be capitulation, and the market has reached a bottom."

These people use the word "confidence" at least once every ten seconds. "The bailout hasn't restored confidence. We have to restore confidence. What can the Fed do next to restore confidence?"

This market crash has never been about confidence. Corporate earnings have been in a bubble for years, and now corporate earnings have been falling, as I've been demonstrating for the last four quarters. This has forced price/earnings ratios (also called "valuations") up to astronomical levels, so that investors' computer models began to say "Sell!" We'll get another earnings report on Friday, so we'll see what comes next.

October 9, 2007, exactly one year ago, was the day on which the Dow index reached its peak. Since then, the market has been falling because of falling corporate earnings.

But now, especially in the last few days, something else is happening.

Stock and bond mutual funds experienced the the greatest level of withdrawals in history in September, and the withdrawals are trending even higher in October. (Paragraph corrected - 15-Oct)

This has had a knock-on effect with commercial paper:

"The U.S. commercial paper market shrank by $56.4 billion in the week ended Wednesday, the fourth consecutive week of declines, according to data released by the Federal Reserve Thursday. ...
In the past few weeks, the decline has been driven by money market funds, which have been worried that the crisis among financial institutions could result in significant losses in their holdings. They have been hoarding their cash for fear of redemptions. Money market funds are the largest buyers of commercial paper, purchasing about a third of outstanding paper. Retirement and pension funds, corporate treasuries and life insurance companies are other buyers.
Investors have been reluctant to buy paper that matures past one day and rates have been elevated. On Thursday, rates on asset-backed commercial paper are quoted lower by about 100 basis points, according to one trader at a primary dealer."

It's this freezing up of the commercial paper market that's caused the greatest pain in the credit crunch. If an organization can't borrow money by issuing commercial paper, then business around the world freezes up, and that's what's happening.

The lack of money to invest is causing investors to pull out of hedge funds.

"Investors can't redeem their money from hedge funds at will; often they have quarterly windows when they can do so. Many investors had until Sept. 30 to tell hedge funds they wanted out. While the funds are typically not required to redeem the money until the end of the year, the redemptions were greater than some funds expected. That caused a scramble to raise cash to pay the investors back. And one quick way to raise cash is often to sell holdings of stock.
For larger investors like pension funds, their own money-raising issues have forced more selling than they would have wanted.
"Pension funds are reducing stakes because they relied on commercial paper for financing and that is frozen," said a person familiar with several hedge funds that have had that problem."

This is causing other knock-on effects.

The country of Iceland, which has been acting like a hedge fund for several years, is approaching closer and closer to full scale bankruptcy, and the currency is crashing.

As hedge funds unwind, they're forced to sell stocks and liquidate other holdings, including metals and other commodities. Copper, aluminum and nickel prices have fallen to three year lows, and oil has fallen sharply as well. The only metal that's gained is gold, which rose to $907 per ounce, but that's still well below its high last year.

It's increasingly clear that a lot of forced selling has been going on since the beginning of the credit crunch a year ago. A year ago, the forced selling was just a trickle. Since then it's accelerated, and today it appears to be an avalanche. At some point, and it can't be too much longer now, the avalanche will accelerate further into a full scale "panic event" that will be remembered for decades.

It's important to understand this, because the 1929 crash was not caused by "loss of confidence," even though Fed Chairman Ben Bernanke has spent his entire career believing that. It was caused by exactly this kind of forced selling. It was a lot simpler then. Individual investors buying stocks on margin were forced to sell to meet margin calls. Forced selling lowers stock prices, which causes more margin calls which causes more forced selling.

But this time, it's not just individual investors meeting margin calls. You've got $60 trillion of interlocked credit default swaps that will have to unwind, and there are other credit derivatives totalling $1 quadrillion.

Thus, the generational panic and crash, when it comes, will be far larger than anything that happened in 1929.

The puzzle, as I've mentioned before, is that the timeline is a little different than it was in 1929. In 1929, there was a huge panic that dropped the market 40%, and after that it kept falling to 10% of its peak value.

Today, a year after the credit crunch began, the market has already fallen 40%, so a generational panic and crash might push the market down another 10-20% pretty quickly. Despite the differing timelines, in the end, though, it's reasonable to expect that the market will do as it did in 1929, ending up at 10% of its peak value, or around Dow 1400, sometime around 2012.

As I'm writing this late Thursday evening ET, Asian markets are still falling sharply, and Wall Street market futures for Friday morning are indicating a sharp fall at the open. That doesn't mean that the market will fall on Friday -- we could certainly have a big one-day rally, as happened more than once after the crash of 1929.

But the most important news is the increase in forced selling. It's creating a vicious cycle (forced selling depresses stock prices, causing more margin calls, causing more forced selling) that has to lead to full scale panic at some point, and that point can't be very far off now.

(Comments: For reader comments, as well as more frequent updates on this subject, see the Financial Topics thread of the Generational Dynamics forum. Read the entire thread for discussions on how to protect your money.) (10-Oct-2008) Permanent Link
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Generational Dynamics Web Log for 10-Oct-2008 Stock market is in free fall, as forced selling accelerates

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Generational Dynamics Web Log for 10-Oct-2008
Stock market is in free fall, as forced selling accelerates