NEW YORK (MarketWatch) -- The capital market machination cracked last week and stopped functioning in an orderly manner.
A few short sessions -- and $1 trillion dollars -- later, many in the mainstream media declared that all is well in the world. While calmer heads are quick to put the panic into perspective -- the S&P 500 (MARKET:SPX) is a mere 5% from fresh 18-month highs -- the system broke, if only for a short period of time. That, by definition, is a crash.
As I wrote last week, there are a few ways to view what happened, ranging from the obvious to the conspiratorial to the nonsensical. At the end of the day -- and from this day forward -- the takeaway has little to do with the "why" and everything to do with the "what." Read Minyanville's "The 1000-point plunge."
Politicians were quick to declare war on the perceived culprits; German Chancellor Angela Merkel lashed out, saying "speculators are our adversaries" and she's "resolved to win the battle against markets." Senator Chris Dodd, chairman of the Senate Banking Committee, said on Sunday that high-frequency trading created a "casino environment" where "finance is getting detached from the real economy."
To be sure, there is plenty of blame to go around. As we've long posited in Minyanville, the spectrum of culpability stretches from over-extended consumers to institutions that financially engineered the markets to policymakers complicit by acceptance. While the system collapsed during the first phase of the financial crisis and snapped anew last week, those events were not the cause of concern -- they were simply the effect.
Long-time readers of Minyanville understand the causal elements of cumulative imbalances and the societal ramifications of percolating class wars, as well as the potential pitfalls inherent in a finance-based, derivative-laced global economy. Those are among the reasons why we warned of "a prolonged period of socioeconomic malaise entirely more depressing than a recession" in the summer of 2006.
Emergency measures; deja vu!
We've long drawn the distinction between drugs that mask the symptoms and medicine that cures the disease, as well as the difference between a legitimate economic recovery and debt-induced largess.Over the weekend, taking a page from the stateside playbook, the European Union crafted a $962 billion emergency loan package with hopes of containing the contagion. Read Minyanville's "A Five-Step Guide to Contagion."
While these numbers are obscene -- by some accounts, ten-fold the size of what was expected -- the reality is that this has been the grand plan for nearly a decade, an attempt to buy time and push obligations out on the time continuum. The more things change the more they stay the same; the more they stay the same, the greater the forward risk. Read Minyanville's "Anatomy of a Recession."
Entering September 2008, with $871 billion in corporate debt coming due in the financial complex, we warned that one of two things would happen. Either markets would experience a cancer that spread through industry sectors or the system, as a whole, would experience a cataclysmic car crash.
The U.S. government took a wait-and-see approach before attempting to "buy the cancer" and "sell the car crash." When they finally bit the bullet, passing TARP on October 3rd, 2008, the S&P fell 500 points -- over 4,000 Dow points -- before finding it's footing five months later.
Last Wednesday, when the specter of "proactive" measures by the ECB kept a tentative bid under a very nervous market, we openly asked if the European Union would take the necessary steps to snuff out the fuse of contagion. Read Minyanville's "Will Europe Order a Code Red?"
The next morning, ECB President Jean-Claude Trichet effectively blew off percolating market concerns by adopting a "What, Me Worrry?" attitude at the ECB meeting and the stage was set for the global fret.
It remains to be seen if this new structural backstop will achieve the desired results -- or if it's logistically feasible -- given the European crisis is but one of many global concerns. Let's not forget that U.S. states are in a similarly dire financial condition, as are many of its citizens. And there's the matter of the crash itself.
The question we must wrestle with is one of psychology, which is "why" the events last Thursday pales in comparison to "what" actually transpired.
Unintended consequences
Faith in the system and the credibility of our leaders has long been fingered as the issue at hand for markets at large.Decisions made in a state of panic tend to have serious repercussions. We witnessed this dynamic evolve during the last 18 months as the unintended consequences of government intervention manifested. From moral hazard to record profits -- and bonuses -- at financial institutions to the attendant class war and shifting social mood, risk wasn't destroyed; it simply changed shape.
What if high-frequency trading actually provides liquidity in the marketplace? It's conceivable that Thursday's 1,000-point swoon was triggered by computerized models "pulling bids" at precisely the same time. If that's the case -- I'm not saying it was, I'm simply posing the possibility -- banning the robots would lead to more, not less, market volatility.
What if "naked CDS" are banned, as we've long suspected might happen? The knee-jerk reaction would likely be a melt-up in the equity space, but we could then see "counter-party contagion" given the $500 trillion dollars of notional derivatives tying the world together.
If you think there was confusion Friday when Mom and Pop couldn't get a handle on their exposure, imagine the domino effect if J.P. Morgan Chase (NYSE:JPM) , Goldman Sachs Group (NYSE:GS) , Bank of America Corp. (NYSE:BAC) , Citigroup (NYSE:C) , and Morgan Stanley (NYSE:MS) suddenly have billions of dollars of unidentified risk.
And what if the reaction to last week's crash causes investors -- many of whom have been burned multiple times during the last decade -- to lose faith in the system, if only for a spell? While psychology can be manipulated for extended periods of time, free will can never be caged. If you doubt that for a moment, read Victor Frankl's "Man's Search for Meaning."
The reaction to the EU Emergency Fund will be entirely more telling than the Fund itself, and while markets feel euphoric thus far this week, there is cause for pause.
According to Jason Goepfert at Sentimentrader.com, there have been six other instances when the market gapped up more than 4%, as it did Monday.
In every single case, the "gap" was eventually filled, and usually very quickly. For purposes of clarity, the downside vacuum in the current marketplace resides under S&P 1,150 (which, if breached, "works" to S&P 1,110) and Nasdaq (NASDAQ:COMP) 1,925 (which, if breached, "works" to NDX 1,850).
While technical context could provide utility in the battle for the few percent, it pales in comparison to the war of words and the monetary mortars flying overhead. Make no mistake, in the eyes of our leaders, the stability and fragility of the global financial markets is a matter of national security and they'll fight to the end to defend their turf.
While speculators and hedge funds are currently in the political crosshairs, widely perceived to be acceptable casualties of the current conflict, the future of free-markets hangs in the balance. Let's just hope that in the quest to win the war on capitalism, we don't lose something entirely more profound in the process.
