Why the Market Is Behaving Badly

Yesterday, we saw what you can do regarding your investing future in the face of severe market turmoil. Today, we'll take a deeper look at the causes behind the volatility and how you can maintain perspective during these difficult times.

Investors were probably hoping that with the debate over raising the debt ceiling settled, without the Treasury defaulting or the U.S. losing its AAA rating (at least for now), that the equity markets would not only recover, but even begin a rally. Unfortunately, equity markets still face a laundry list of headwinds, many of which are eerily similar to the headwinds investors were worried about a year ago. Let's look at the list of issues investors are concerned about.

Photo courtesy of Katrina.Tuliao on Flickr.

Next: PIGS

Portugal, Italy, Ireland, Greece and Spain

PIGS European nations have been experiencing financial difficulties far beyond what the U.S. has been facing. A year ago, we were dealing with the PIGS:

Portugal
Ireland
Greece
Spain, which has the fourth largest economy in Europe

Today, not much has changed, except now you can add Italy and its third largest economy in Europe (seventh largest in world) to the list. Investors are also concerned that the recent package put together by the various European governments just isn't big enough to handle the stresses across the continent. All of Europe is facing fiscal austerity measures at a time when their economies are experiencing sluggish growth at best.

As interest rates rise on Italian, Spanish and Portuguese debt, it makes it harder to finance their debt, causing the potential for disruption. While Greece seems certain to default in one form or another, it's critical for markets that Spain and Italy (due to their sizes) not go down that path. We can think of Italy as not only too big to fail, it might be too big to save if it can't solve its problems on its own. If either defaulted, it might signal the end of the Eurozone (something that the political leaders will go to great lengths to avoid).

It's extremely important to understand that banks in the Eurozone own so much debt of their own country and other Eurozone members that they're in danger, and the downgrades and falling values are hitting their balance sheets hard, not only creating capital problems but constraining their ability to lend. The issues of weak European economic growth, austerity measures and bank capital problems create additional hurdles for U.S. growth, as our ability to export is hampered.

Photo courtesy of peter pearson on Flickr.

Next: Housing, Unemployment and the Environment

Housing A year ago, we were faced with concerns that housing prices were continuing to fall. Nothing has changed as the trend has continued.

Unemployment A year ago the unemployment rate was 9.6 percent and trending down. Now, it's 9.2 percent and heading in the wrong direction. With the prospects for federal fiscal austerity and continuing cutbacks from state and local governments, it's difficult to see how the rate can fall much, especially in light of all the discouraged workers who could re-enter the workforce at some point. The labor force participation rate for June had fallen to 64.1 percent because more than three million people simply gave up looking.

Oil and Nuclear Disasters A year ago, we were worried about the economic impact of the oil spill in the Gulf of Mexico. This year, we're worried about the economic effects of the earthquake, tsunami and nuclear disaster in Japan, the third largest economy in the world.

Photo courtesy of taxbrackets.org

Next: Market Prices and Debt-to-GDP

The Dollar and Commodities Prices A year ago we were worried about a collapsing dollar and a rise in commodity prices, especially gold. Today, the story is no different.

S&P 500 In just the two short months from May 3, 2010 to July 2, 2010 the S&P 500 Index fell from 1,202 to 1,023, a drop of almost 15 percent. The recent performance of the market is eerily similar.

Debt-to-GDP The deal to raise the debt ceiling really did nothing to bend the cost curve. We're still heading fairly rapidly for a debt-to-GDP ratio of 100 percent, a point at which it becomes difficult to finance.

A study by Kenneth Rogoff and Carmen Reinhart found that a debt ratio above 90 percent results in 1 percent slower GDP growth, making it more difficult to grow out of the problem (as you can't generate sufficient revenue). Thus, the 90 percent debt level becomes almost a "line in the sand."

The CBO estimates that the recent deal just delayed that time until 2021, less than a decade away. The reason is that it didn't attack the real problem of entitlements, the Holy Trinity of Social Security, Medicare, and Medicaid.

Photo courtesy of DFID on Flickr.

Next: Foreign Affairs, Monetary Stimulus and Domestic Growth

Foreign Affairs We shouldn't forget the situation in the Middle East, with several countries facing great uncertainty, including Libya, Syria and Yemen, let alone the continued threat posed by Iran and the Palestinian situation.

Monetary Stimulus During the 2008 recession, the economy received a tremendous amount of fiscal and monetary stimulus, in the form of a massive increase in government spending and the Federal Reserve driving interest rates to zero along with two quantitative easing programs. This time, neither is going to happen. With the Federal debt already at such high levels, there's no room for that kind of fiscal stimulus. And with the Fed funds rate at zero, there's no way to lower rates further -- though the Fed can lower the rate, currently 0.25 percent, that it pays banks on deposits, providing them an incentive to put that money to work.

Domestic Growth Adding to our concerns is that US economic growth has slowed dramatically. Some indicators are barely above levels that would indicate that the economy is contracting:

First quarter growth was revised down to just 0.4 percent, and second quarter growth came in at just 1.3 percent (and some of that growth was due to slower import growth, not necessarily a good sign).
Consumer spending turned negative (-0.2 percent) in June, the biggest drop since September 2009, as the personal saving rate rose to 5.4 percent in June, the highest since August 2010.

The bottom line is that consumers are deleveraging. And the uncertainty is likely to continue for the rest of this year. We have a Congressional commission that will try to come to the grand bargain that finally bends the curve on the deficit. Unfortunately, we have two sides ideologically opposed to compromise as their views as to the solution -- the type of economy we should have -- are diametrically opposed. So it's hard to see a resolution. And markets hate uncertainty.

Photo courtesy of wwarby on Flickr.

Next: The Three Characteristics of Financial Crises

The Three Characteristics of Financial Crises Another important point to keep in mind is that Rogoff and Reinhart found that financial crises tend to be protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics.

First, asset market collapses are deep and prolonged. Real housing prices decline an average of 35 percent stretched out over six years (we're now in the fourth year), while equity price collapses average 55 percent over a downturn of about three and a half years.

Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which averages more than four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn (about two years) is considerably shorter than for unemployment.

Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post-World War II episodes. So far, it doesn't seem that this time is much different.

As you can see, there's a tremendous amount of uncertainty. That uncertainty is causing risk premiums demanded to rise. And rising risk premiums are what cause severe bear markets.

Photo courtesy of Kheel Center, Cornell University on Flickr.

Next: How to Keep a Balanced Perspective

How to Keep a Balanced Perspective While none of the information I have shared is good news, it's important to remember that all of it is already known. Thus the information should be embedded in prices. The problem is that we often see selling beget more selling, even without any more bad news or news that was worse than already expected. This can happen for several reasons:

Investors were overconfident about their ability to take risk, and they eventually reach their GMO point -- when their stomach screams get me out and the head can no longer resist.
Momentum players trade on the downward movement, exacerbating the trend.
Margin calls have to be met and some cannot do so creating forced selling and the trend continues...until it stops. And turbulence can lead to regulators increasing the amount of margin required, which can then in turn increase the selling pressure.

With all this in mind, it's important to remember that we faced a similar situation in March 2009, and the market proceeded to provide a return of about 100 percent over the next two years. So now let's try to provide a more balanced perspective by looking at some more positive information.

While the falling dollar has led to increases in the dollar prices of commodities, the falling dollar has positive benefits for the economy. First, our exports become more competitive and imports less so. That helps stimulate growth. Second, reduced competition from imports helps corporate profit margins. Third, foreign earnings increase in dollar terms.
Oil prices have fallen quite a bit. For example, on April 29 the price of oil on the New York Mercantile Exchange was about $114 a barrel. On August 3, it was trading at less than $87, a drop of 24 percent in just over four months. That drop has a similar effect as a tax cut.
Interest rates have fallen across the board. For example, on February 8, the 10-year Treasury yield was 3.75 percent. On August 3, it was trading below 2.4 percent. That impacts the costs of many other forms of borrowing, including mortgages.
Corporate earnings are strong. In 2010, S&P 500 earnings were about $84. The full year estimates for 2011 are now in the mid $90s, and the current run rate is about $100. With the S&P 500 now around 1,200, valuations certainly aren't expensive from a historical perspective (though they can get a lot more "attractive").
Growth in China and India continues to be strong, even if slowing a bit.
The Japanese economy has bounced back rapidly.

And finally, while the options for policy responses by governments and central banks are now more limited, constrained by total debt levels and already low interest rates, it's important to remember that crises tend to provoke reactions to counter the problem, forcing actions (difficult decisions) that might not otherwise be taken. Panic causes many investors to fail to consider this in their decision making.

Photo courtesy of sjorford on Flickr.
More on MoneyWatch:
Don't Panic: Stock Market Crises Are Normal Investors Continue Moving to Passive Management Goldman Sachs: Does It Add Value? Stocks Down 12& in 9 Days -- Here's Why Why I'm Buying Stocks Today
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Larry Swedroe

Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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