Everything that goes up eventually goes down — especially in the stock market, where investors throughout the world recently saw their portfolios suffer a major blow after registering strong performances for several months. The appetite for risk that players in the market had acquired in a risk-free environment wound up leading to indigestion because of uncertainties created largely in the United States, China and Japan. Experts say that these shocks have given investors a chance to take some profits after enjoying a period of continuous price increases. They also contend that the recent plunge is merely a healthy correction, and that the market will once again provide attractive opportunities.
Over the course of just five days, the principal stock exchanges of Europe lost an average of 6.9%. The Ibex 35 was battered the most, dropping by 7.5%, which translated into 37 billion euros in lost market capitalization. In the United States, the Dow Jones dropped 4.6% and the S&P 500 dropped 5.19%. These declines are slight in comparison with the losses suffered in the stock exchanges of emerging markets. In Latin America, the Buenos Aires exchange plunged 12.58% during this period; the Bovespa in Brazil dropped 10.88% and the IPC in Mexico fell by 8.05%.
All of these strong declines were accompanied by a tremendous volatility in the market, experts note. The VIX index of the Chicago exchange, used since 1990 as a guide for measuring volatility, has risen to 20 points, a level not reached since the strong correction that markets suffered between May and June last year. Nevertheless, this is far from the more than 46 points registered at the beginning of 1999 during the height of the technology bubble.
The Chinese Sneeze
The markets were shaken by the possibility that the Chinese government would impose taxes aimed at stopping speculative activity and controlling the speed of growth in the country’s market, which has doubled in value over the past 12 months. The rumors set off a sudden wave of selling in China, sending prices down 9% in a single day. “This is not the best way to begin the Year of the Pig, but a correction is what we had expected, and that’s what happened,” says Lorraine Tan, vice-president of Standard & Poor’s in Asia.
The sharp drop in the China markets, followed by a large drop in the U.S. markets, reflect the emergence of China as a top-tier player in the world economy and financial markets. “The declines in global markets after the collapse in Shanghai are an indication of the growing importance of China’s fortunes (in the global economy),” adds Tan.
These anxieties stem from the fact that strong economic growth in Asia — and in China in particular — has driven the global economy in recent years. Any problem in that part of the world would have very negative consequences for the economy, business profits, liquidity, and appetite for global risk. Stephen King, chief economist for HSBC in London, told the Spanish newspaper Expansion that sees “a change in the center of gravity” for the world economy.
The U.S.Adds Fuel to the Fire
The comments of Alan Greenspan, former head of the Federal Reserve, along with disappointing economic data showing a break from recent positive growth figures, added to worries about a possible recession in the U.S. “Both factors staggered investors, leading to the fall in stock markets in the U.S., the U.K., Europe and Asia,” says a report from Shroders, the British management firm.
Juan Mascareñas, professor at the Complutense University in Madrid, explains that managers of international funds buy and sell with one eye trained on the most important stock market of the world, the New York Stock Exchange. “Any news that affects that market, whether domestic or international, affects the rest of the markets to a greater or lesser degree. A slowdown in the American economy implies that future growth in the profitability of U.S. companies will decline, which would have repercussions in the market for those companies’ shares.”
Greenspan’s commentary came only a few days after Ben Bernanke, current president of the Fed, said that he was optimistic about the U.S. economy. Bernanke foresaw a smooth landing with less impact from the fall in the real estate market than anticipated earlier, as well as a gradual decline in inflation. Bernanke’s comments led people to believe that the upward cycle in interest rates, currently at 5.25%, is coming to an end. The growing consensus was that the Fed would move to drop the price of money before the end of this year.
Japanand the ‘Carry Trade’
Another factor that produced a domino effect in global markets was the strong appreciation of the Japanese yen relative to other major world currencies. The yen is at its highest level in three months versus the U.S. dollar, euro and pound sterling, because of a fiasco concerning arbitrage between various interest rates (the carry trade). Ever since the Shanghai exchange plunged, doubts about the U.S. economy have increased, along with a significant increase in volatility and risk aversion. To the degree that investors unload positions that were propped up through carry trade, the yen has gained value. The rise of the yen has forced other investors to unload their positions. Ultimately, this process has degenerated into a spiral.
As a result, the Tokyo stock exchange recently registered strong declines of between 3% and 4% a day (in its Topix index). This had a domino effect on other stock markets in Asia and around the world. Eisuke Sakakibara, formally the second-ranked official at Japan’s Ministry of Finance, is known as Mr. Yen, because of his role managing the Japanese currency between 1997 and 1999. A few days ago, Sakakibara reportedly said that “the carry trade will continue for some time.” Meanwhile, the finance ministers of the G-7 group of nations warned investors in their latest meeting about the dangers of “betting in only one direction,” an implicit reference to the carry trade.
An Easy Cocktail to Overcome
Uncertainties created by the Chinese government, the danger of a harsher economic slowdown than anticipated, and doubts awakened by the strong appreciation of the Japanese yen have all combined to create a cocktail that investors used as an excuse to cash in their chips. Nevertheless, experts are optimistic in the short term, arguing that this is more of a healthy correction than a big change.
There were reasons why prices collapsed, say the experts. Before the correction began, Spain’s Ibex 35 had gained 33% from its low point in June 2006. “This is an exaggerated correction, with justification that is excessive. It has produced a contagious impact, and nobody wants to be the last person to stay in the market,” says Alberto Roldán an analyst from Inverseguros, the Spanish brokerage. “These situations are created in stages, and they are normal and healthy,” says David Pocino from Banco Urquijo. For Renta 4, the Spanish stock brokerage, “the market was overvalued, and this correction was anticipated.”
For all that, the latest price declines do not change experts’ favorable view of the market. “No structural change has been produced,” adds Pocino from Banco Urquijo. Like other experts, that institution notes that the more forceful the decline, the greater the subsequent rebound. José Luis Martínez, strategist from Citigroup in Spain says it is possible that there will be greater instability in the short run, but it does not anticipate that markets will suffer a series of price declines that will last several months.
Altina Sebastián, finance professor at the Complutense University in Madrid, notes that prices for variable income debt instruments are still attractive, especially compared with alternative assets. “Fixed income is expensive and the real estate market appears to have hit a ceiling. And raw materials, which had reached unprecedented price levels, appear to be starting to stabilize or to drop.”
Sergio Torassa, finance professor at European University, argues that corporate performance will continue to act as a factor that drives stock prices. According to a study published by Atlas Capital, mergers and acquisitions reached a volume of 190 billion euros in Spain last year, up 70% from 2005. “It is almost certain that this trend will continue through 2007,” adds Torassa.
Reacting with Defensive Assets
Not all assets have been behaving in a negative way during this period of correction. Money has fled the stock market for other markets that have traditionally acted as a refuge during periods of uncertainty. Prices for two-year to 10-year bonds are rising — returns on bonds behave in an inverse way from their prices — the same way that bond prices are rising on the other side of the Atlantic. The return on the German 10-year bond dropped in only a few years from 3.995% to 3.915% as the price dropped, while U.S. bonds behaved likewise; their returns dropped from 4.625% to 4.495%. Over the last two years, the German bond has dropped from 3.933% to 3.842%.
“People are afraid that the market can do the same thing now as it did in May 2006. So they could need to wait for a 10% drop before starting to buy. Investors are remaining liquid, or they are investing in very short-term fixed income,” explains the subsidiary of Société Générale Selftrade, a French company, in a report. “Short-term fixed income instruments have always behaved well in periods when the stock market is undergoing convulsions,” says JP Morgan Asset Management in a report.
Recent instability in the stock market is also driving some investors into derivative products. On March 1, the warrants business on the Spanish market reached a record high of 33.94 million euros. According to Société Générale [Selftrade], this figure is 32% higher than the previous record achieved last February 8.