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What Caused the Latest Swoon?

On Wednesday, the S&P 500 Index fell 4.4 percent. This followed drops of 6.7 percent on August 8 and 4.8 percent on August 3. This kind of volatility brought back painful memories of the 10 trading days from September 26, 2008 to October 10, 2008 when the S&P 500 dropped 26 percent, including daily drops of 8.8 percent, 4.0, 5.7 and 7.6 percent. And the 26 percent drop turned into a cumulative fall of 56 percent by the time the index hit bottom on March 9, 2009.

Investors hate uncertainty, and they've been hit with an almost daily barrage of uncertainty, from the cliffhanging debate over the debt ceiling, to the downgrade of the Treasury's credit rating, to downward revisions to the GDP and weak economic data in general, to the crisis in Greece and the risk of it spreading to Italy, Portugal and Spain. The sharp drop Wednesday was triggered by rumors about a downgrade of France's AAA rating (as the country's debt-to-GDP ratio is about 85 percent, the highest of any of Europe's AAA club) and troubles at Societe Generale, one of the largest French banks and one that saw its shares fall 18 percent. The rumors that SocGen was having trouble obtaining funding caused French bank stocks to fall sharply. Then, U.S. financial stocks fell by more than 7 percent, because of fears about exposure to French banks as shares in those institutions dropped during European trading.

The balance sheets of French banks are loaded with the debt of Italy, Greece and other troubled European countries that share the euro currency. The great fear is that France will have to bail out its own banks as well as help in a bailout of Spain and Italy. This fear is reflected in the extra yield investors demanded to buy 10-year French debt rather than German bonds, which jumped to 90 basis points even though both carry AAA grades from the major rating companies. That spread is almost triple the 2010 average of 33, and compares with 17 in the second half of the previous decade. The head of the French central bank, Christian Noyer, held a meeting with the heads of major French banks and President Nicolas Sarkozy to address the problem.

The uncertainty created by these series of crises -- along with the recent memory of the 2008 crisis -- has caused many investors to panic and many more to lose sleep as their stomachs reach the GMO point (when it screams "Get me out!"), and even the best laid plans end up in the trash heap of fear. The increased uncertainty is what causes investors to demand greater risk premiums. Prices fall, but expected future returns rise. In other words, those who sell during crises/panics are selling just when expected returns are highest. Those very same people tend to buy after bull markets when things look safe and thus expected future returns are low. Selling when expected returns are high and buying when they are low isn't a good strategy.

Given the heightened risks, it's important to keep a proper perspective. First, the risks are well known, and the bad news is thus already embedded in prices. Second, U.S. financial institutions are in better shape than their European counterparts, because they were forced to raise huge amounts of capital under the terms of the TARP program. In addition, they have much lower exposures to European risks than do European banks. In other words, the drop in the U.S. market wasn't caused by a major U.S. problem. Third, while there's certainly the possibility that a European banking crisis could develop, it's likely that Europe would take actions to address the problem, just as our Federal Reserve and government did. In fact, we have already seen the European Central Bank begin a program to drive down rates on Spanish and Italian bonds by purchasing them in the open market. And the French government would take whatever actions are needed to keep its banking system solvent.

In fact, it appears that Europe is now following the same prescription the Fed followed that eventually fueled the economic recovery and the greatest bull market since the 1930s. It appears there's now an end to talk of the ECB raising interest rates, and perhaps even lower them. And via its purchases of Spanish and Italian bonds, the ECB has adopted its own form of quantitative easing. Perhaps a next step would be forcing banks to add capital, as the U.S. government did. While my crystal ball is cloudy, the virtual certainty is that we'll see actions by governments and the ECB if further problems develop. This doesn't mean there's not risk. Thus, you should be sure that your investment plan doesn't have you taking more risk than you have the ability, willingness or need to take.

And finally, yesterday's fall in equity markets around the globe was another reminder that diversification across risky assets works in the long term, not necessarily in the short term. Thus, it's critical to understand when designing your investment plan that the most important diversification involves having sufficient fixed income assets of the highest quality to dampen your portfolio's overall risk to an acceptable level. Note that each day that the equity markets have been hit hard, safe fixed income assets (such as Treasuries) have experienced strong rallies. In other words, during crisis, while the correlation of risky assets tends to move toward +1, the correlation of safe assets to risky assets tends to move toward -1.

Photo courtesy of Perpetualtourist2000 on Flickr.
More on MoneyWatch:
The Ben Bernanke Rally Implications of the S&P Downgrade How Markets Have Responded to Past Sovereign Downgrades Why the Market Is Behaving Badly Don't Panic: Stock Market Crises Are Normal
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