The Impact of Thursday's Stock Market Swoon

In my last posting, I mentioned that the sentiment indicator I follow had reached levels that signaled a correction, but not the end of the current cyclical bull market. I had pared back my holdings in the T. Rowe Price New Asia Fund, but was waiting to reduce holdings in the S&P 500 Index Fund because I anticipated a last leg upward resulting from increasing interest in the stock market by individuals who had preferred the fixed income area since early 2009.

Last Thursday's swoon took the market down to correction levels (a minimum ten percent from the highs in late April) before recovering somewhat. Unfortunately, this decline was exacerbated by a defect in our trading system. The NYSE, which accounted for all of the trading in their listed stocks when I first started on Wall Street in 1968, now accounts for roughly a quarter of the volume. There are a number of computerized exchanges that trade NYSE listed stocks. In addition, with the "retail" (individual) investor not investing in equities as much as during prior bull markets, more than half of overall trading volume is what is known as "high frequency, computerized" trading among computers. The computers are programmed to react to various price points in individual stocks with stop loss or market orders. Last Thursday, the NYSE slowed its trading to mute the downward pressure on stock prices but the other exchanges did not. The market and stop loss orders that were triggered by the computers were filled elsewhere, where there was little liquidity. Thus, the stock of Procter and Gamble, one of the stalwart companies in our economy, fell from around $60 a share to under $40 in less than fifteen minutes!

Since I am a firm believer in the old adage "Necessity is the mother &%*#!& of invention!", there will be new regulations resulting from this debacle. Hopefully, they won't go too far. At the very least, however, all exchanges should adopt the same "circuit breaker" rules, so that a halt in trading at one exchange doesn't divert orders to the computerized exchanges where liquidity has dried up.

What is the impact of last Thursday's swoon on future consumer spending? Historically, on October 19, 1987, there was a worse computerized trading experience when "portfolio insurance" trades were primarily responsible for a more than TWENTY PERCENT DECLINE in the stock market in ONE DAY. At that time, I mistakenly thought a bear market in one day would immediately cause a recession, but one didn't occur for several years thereafter. With that in mind, I don't believe Thursday's milder decline will precipitate a recession, although it may temporarily dampen the spending of those who had felt much wealthier due to the stock market's strong move from the bottom in March, 2009.

As for the impact on the individual investor, last Thursday's experience can only reinforce the prevailing opinion that Wall Street is one big casino with the individual player attempting to plan for retirement in a rigged market. The timing couldn't have been worse because individuals, with low expected future fixed income returns and lower than normal equity exposures, were beginning to return to the stock market. This may still occur for the lack of alternatives but it will be more muted.

I haven't yet reduced my exposure to equities since my last posting, but I am becoming more nervous.

In previous postings I have emphasized that the deleveraging process will be ongoing for years. After all, the leveraging occurred over several decades. Deleveraging, as we are seeing in the case of Greece, involves higher taxes and reduced spending. Several states here with large deficits will be forced to continue engaging in similar austerity measures. Such action argues for lower than normal domestic economic growth.

In that context, I suggest reading an article entitled "The Changing Cyclical Contours of the U.S. Economy", written by Lakshman Acuthan of the Economic Cycle Research Institute. I have been impressed by his previous writing. In this piece, he shows that future GDP growth will be lower and the volatility of that growth higher, with the result that recessions will be more frequent. This scenario, I would think, argues for more trading around a reduced core equity exposure.