Liquidity is the chief factor to watch

“What was that?” wrote one of our clients earlier this afternoon.

One week ago, the Dow was at all-time highs, the S&P 500 and NASDAQ at six year highs and the S&P 500 was within a few percent of making a new all-time high.  Today, S&P 500 fell 3.47%, down 4.15% from the year’s high and down 1.18% on the year.  The NASDAQ fell 3.86% on the day, 4.64% in the last three days, but remains up 0.31% on the year.  Government bonds rallied in a flight to quality, but corporates fell as credit spreads widened.  The dollar fell as US interest rate returns fell relative to the Euro and Pound. 

The triggers were a 9% fall in the Chinese stock market last night on news that China’s government was looking into blocking illegal margin trading, news that US Vice President Cheney narrowly missed injury from a Taliban suicide bomber, and a worse than expected durable goods report in the US. 

By 11:30 AM, just as we saw in the October 1987 stock market crash, the computers took over, sending wave after wave of sell programs to the exchanges.  Thanks to advances in investment products such as Exchange Traded Funds (ETF’s), and advances such as “algorithmic trading” where computers blindly buy and short stocks based on miniscule fluctuations in valuation, investors can short the market at the click of a mouse.  Unfortunately, there’s no guarantee that someone will take the other side of the trade when massive sales hit the markets.  Stocks “gap down” rather than trade smoothly, which messes up the trading programs.  At 3PM, some sort of NYSE computer glitch caused the Dow to fall 156 points in a minute (the Dow was down nearly 550 points at that point, ultimately settling down 415.)

Was this correction a surprise?  Not really.  From the lows of last summer to last week’s high, the S&P 500 gained 19.9% - not bad for 8 months.  In recent weeks, we’ve had that “skating on thin ice” feeling – stocks have performed too well for too long.  Unfortunately, we never can anticipate exactly when stocks will take their correction (anytime in the last three months would have been a fair guess.)  Our strategy assumes that events like this will occur and we position ourselves accordingly.

·         We do don’t buy stocks on margin (so we’re never forced to sell into margin calls.)

·         We remain leery of investing in “emerging markets.”   Yes, there are fantastic returns as we saw last year (38.55% in the Citigroup BMI Emerging Markets Index), but also the risk of fantastic losses.

·         We invest in companies with real products, real revenues, and real earnings – companies that can ride out financial storms. 

What happens next?  This correction, or mini-crash, or whatever you want to call it, brings to mind both the October 1987 stock market crash in the US and the 1997 “Asian Contagion” financial crisis, which morphed into the Russian crisis of 1998, which resulted in the failure of Long Term Capital, a hedge fund, which threatened the solvency of the US monetary system.