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Stock Market Collapse ... Panic
by Tony Butcher
2007-03-03 10:59:47
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If you follow any of the financial news or global stock markets at the moment you will be reading about the equity correction that is happening at the moment. Every stock market in the world has been giving up some of the strong gains seen over the last 18 months. But the question is will this be the start of a major economic meltdown or is this just a pull back after a terrific bull run.

In my opinion you have to examine what is driving the markets lower and why the sell-off has been so aggressive. By starting with such a basic cause and effect analysis this should help to keep any investment decisions based on rational thinking as opposed to media panic.

So what has happened in the world to start the correction? On Tuesday 27th March there were reports from China that the government was going to tighten the laws on investing capital in equities using borrowed money. This had a significant direct implication for carry trades and the instant reaction of causing the Shanghai index to lose 9% in value. Major European bourses then tracked those losses through the day finishing down around 1.5% on average. However, it was trading in the United States, after the European close, which really made the headline writers sharpen their pencils.

The Dow Jones was trading around 350 points lower when a trading program, which helps to calculate the overall index by time filtering the trades, collapsed causing the market to plunge a further 178 points almost instantly – when it instantly calculated the effects of trades done earlier in the day. This had knock on effects on the debt markets as the “flight-to-quality” saw traders buying bonds in US Government securities, which was mirrored in Europe. As automatic stop losses were triggered the move was both extreme and fast. The Dow Jones did recover some losses but the continuing effect carried over to the next day when European stocks reopened losing a further 1-1.5%.

The concern over carry trades is significant because it has been a popular way of taking advantage of low interest rates in specific economies to invest the capital in higher yielding investments. For example, if you borrow several million Yen from Japan, base rate is currently about 0.5%, and converted the currency into dollars to invest in secure Government debt, which would yield around 4%-5%, then the trade makes the difference in yield as profit with only the currency risk becoming a factor. Of course the high the return you can get on the capital the more attractive the trade, hence the heavy investment in higher risk/higher return areas such as China.

What has been happening recently though is that carry trades have also been making extra profits from the currency movements as the Yen has weakened against other major currencies. The tightening of Chinese policy would have caused investment capital to be unwound and the carry trades to be taken off. As investment capital sold US stocks the Yen also began to strengthen against the Dollar and this perpetuates the current cycle. Carry trades are not a new phenomenon they have been used for decades and in the past have been a factor in sharp market corrections. Refer to a warning from Nouriel Roubini’s blog on the 1st Feb 2007.

We now have a situation that as the Yen strengthens more, then carry trades will continue to be unwound and the global stock markets will suffer more. As the stock markets drop more investment capital will move into traditionally secure products such as Bonds. There is a further effect that because of this buying of Bonds, interest rate futures markets in the United States have begun pricing in a 100% chance of two rate cuts by the end of 2007. This is in stark contrast to the opinions given by Federal Reserve Chairman Benjamin Bernanke who is upbeat on US growth and confident with controlling inflation and has not hinted or positioned the FOMC (Federal Open Market Committee) for such a move.

That has examined the cause of the sell off and what is currently driving the markets to their multi-month lows. But taken in context of the wider stock market performance this is, so far, not something to panic over as the Dow Jones has gains (at its peak) of around 16% this year, the last few days has seen a 3% pull back. In the light of a reasonably strong US economy then I would expect to see the bull market continue as traders start to see value in equity markets again. That is not to say we could see a little more pain before the gains, in 1998 the Yen corrected from 134 to 118 in 72 hours (a 12% appreciation against the US dollar). In fact there was a trader who bought two Porsche 911’s with a trade he made, one has a number plate of “911 134” the other “911 118” to remind him of his buy and sell price. Go cautiously, but don’t panic just yet.

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Asa2007-03-04 13:54:17
I wish I had known earlier...I went and liquidated my stocks...although it did make nice gravy...

I almost understood what happened now!

Lee2007-03-05 03:59:36
I really wouldn't be surprised to see these stock markets come down below the big levels in the next few days

Tony2007-03-05 10:28:04
It's all about the Yen at the moment. I agree the FTSE & Dax 6000 levels will be interesting and the DOW Jones trading around 12000 will be worth watching.

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