Posted on May 11, 2011 by David Laidlaw 

At one point, the equity markets plunged almost 9% last Thursday before rebounding to close down about 3.25% for the session. The wild swings were reminiscent of the fall of 2008 and March of last year when panic selling drove the market down significantly. The sell off extended to Friday and the S&P 500 closed down about 7% for the whole week erasing all gains in the market year-to-date. There are a few rationales for last week’s panic and a great deal of unknowns.

The market has appreciated dramatically from its trough last year. From its low on March 9, 2009 until last Wednesday’s close, the S&P 500 had appreciated by over 70% without any corrections along the way. As we know, common stocks are volatile and returns are never linear. Therefore, the market has been due for a correction for quite some period.

Part of the crisis that gripped the market during 2008 and early 2009 was due to credit problems at large financial institutions. Many assets (especially sub-prime mortgages) were over-valued on the books of the world’s largest banks. The banks then refused to lend to businesses and each other since they were basically afraid that their counterparties would go bankrupt and not make good on their loans. This credit crisis froze markets and caused a deep economic recession. To counteract this contraction of credit, central banks around the world  lowered interest rates drastically and governments guaranteed loans so that financial institutions would start lending again. During this process, governments borrowed aggressively and basically transferred financial debt to their own balance sheets. This proactive move eased the panic and has helped markets in many different areas rebound.

The European situation is scary because weak sovereign nations such as Greece do not have the financial strength to pay back the debts that they have incurred.  At the same time, the population is rejecting any fiscal restraints and violently rioting suggesting that the political will is not strong enough to deal with the problem. Greece is a small country and only represents about 2% of Europe’s economy. However, the market reaction suggests that the contagion could spread to other countries such as Spain, Portugal, Ireland and Italy which are larger and whose default could seriously threaten the stability of the European Economic Union. 

Over the weekend, the European Union agreed to extend loans to countries such as Greece that come under pressure and face default on their obligations. The loan package reached a staggering total of close to $1 trillion. This news has brought about a rally since the fears of a breakup in the EU are greatly diminished over the near term. However, long term there does not appear to be a mechanism in place  to prevent countries from borrowing beyond their means. The credit quality of government debt both here and abroad will remain a vital concern until real constraints on spending are put in place. 

The panic selling during Thursday’s decline also caused unexplained malfunctions on the exchanges as prices gyrated wildly. The majority of shares traded are processed by high frequency trading platforms which are designed to execute at the best available price, but are not designed to halt trading during abnormal markets. Therefore, if the volume of buying falls, selling will continue even at lower prices as long as the price is the best available. These trading programs increase market efficiencies by guaranteeing best execution, but can amplify volatile markets. Please note that while we trade electronically, we do so with direct oversight. We ensure that bid-ask spreads are within our price targets and that there is enough liquidity to handle our order. We did not sell shares last Thursday as we saw spreads widen and liquidity on the buy side fall. We knew Procter & Gamble was worth more than the $39 per share.

While we will monitor these developments with vigilance, we believe that the strength in the US economy and corporate profits will not cause a repeat of the 2008 crash. The economy is growing now at a rate of over 3% per year and most economists expect 2nd Quarter growth to be as strong or stronger than in the 1st Quarter. Lost in the negative news last week, the jobs report showed that the expansion in the labor markets is getting stronger. Payrolls increased by 290,000 during April and revised numbers for February and March suggest that 39,000 and 230,000 jobs were created during these months respectively. Finally, earnings season has passed and the majority of companies have produced very strong profits. Roughly 3/4 of companies produced earnings which exceeded analysts expectations. Additionally, those earnings were 45% higher than during the 1st Quarter of 2009. Given this positive economic and earnings backdrop, we do not believe the heavy selling last week portends the beginning of another crisis for the US markets.