Thursday, October 16, 2008

Dr. Ed's Explanation For Yesterday's Stock Tailspin

By their very nature panic-driven markets defy rational understanding, but yesterday's plunge simply made no sense to me. The weak economic data was blamed for the big drop in stocks by most of the media that I have read, but as I went to bed last night, in my mind the weak retail numbers alone just did not justify a 700 point fall on the Dow. Everyone knows that there is a gawkers affect, and the constant headlines of bank bailouts and failures would certainly keep people away from the malls. It just did not add up to me that the market could not see that the cavalry was on the way. With all of the assistance world governments are giving banks, the new programs for troubled homeowners, and a new stimulus package moving through Congress, it would have seemed that the markets should have reacted far less violently. I believe my suspicions were answered this morning when I read Dr. Ed Yardeni's morning economic report. Dr. Ed, a widely respected economist, reported that investors had pulled $43 billion from hedge funds in September alone. He went on to say that as a result of the demise of Lehman Brothers and the pull back in higher-risk lending by investment banks and commercial banks the world over, that the hedge funds are under siege. In short, their lending sources have all but dried up. Thus, when investors want out, the hedge funds have no choice but to sell stocks no matter what the price. That is what Dr. Ed is convinced drove the Dow's fall yesterday. That makes much more sense to me than the market's reaction to a weak economic number that will be adjusted many times in the coming months before we know for sure how the economy is faring. I have spoken before of the reasonably good long-term correlation between GDP and the Dow. It's not tit for tat, but particularly since 1960, the two have moved together. With yesterday's close around 8,500 on the Dow, the Dow is back to were it was in 2002. At that time, the cumulative real GDP of the US was just under $10 trillion. The most recent reading of GDP is $11.8 trillion, nearly 12% higher. With the Dow at this level, that would mean that the economy has grown by nearly its long-term average over the past six years and stocks have not grown at all. Inflation is the only headwind that could cause the Dow's current reading to accurately reflect the value of its 30 stocks. With oil having fallen to under $80 p/b, it is clear that inflation will be falling in the months ahead. Today's CPI showed zero headline inflation and .1% at the core level. The are many unknowns in all the new governmental plans to bail out the banks and stimulate the economy, but we remain convinced these plans will do their jobs, and that as consumers become more confident of this, they will not continue to stay at home and eat microwave dinners. There will be more spells of hedge fund selling, but their selling has very little to do with the underlying values of the companies that they are selling. Their selling is just bailing out to payoff exiting customers. As the bank stabilization plans come clearer into view, we believe the hedge fund selling will likely diminish, if not turn to buying. I am in Dallas Texas for my oldest son's wedding. He is marrying a wonderful belle of Texas. He asked me just a few weeks ago what I thought the future was for his generation in light of all the problems in the economy. I laughed and told him that I wondered the very same thing when his mother, Joyce, and I got married years ago during the first oil OPEC embargo. I told him the world is far from perfect but that progress is unstoppable. Where free men and women are given the tools, they will always innovate and come up with better ways of doing things. And these better ways of doing things need lots of people to make them happen and move them around the world. Furthermore, I told him, he and his new bride would help cause this new world of innovation to unfold. Justin is getting his PhD in Informatics from Indiana University. He works in areas I cannot describe. How can he or I be pessimistic with this new generation of thinkers and doers on the move?