If only it were a mistake…
By Daniel M. Ryan
Last Thursday was not a good day for the U.S. stock markets. It started off with barely a decline, but the drop accelerated as the day wore on. By the time the panic was triggered, assuming it was right at 2 PM, the S&P 500 was already down 1.8%. A graph of the average shows the free-fall didn't take place until 2:30, a more likely time for any such mistake to have been made. At that point, the S&P 500 was down 2.8%. After the dust settled at the close, the average was down 3.16%. Drawing a line between 2 PM's figure and the close's, results in a path that looks close to an extension of earlier trading. As for Friday: after it had been generally accepted that the market has plunged because of that trading mistake, the S&P still closed down 1.53%. Rather than relief, the next morning's trading saw the average make its low of the day by 10:30 AM.
Clearly, something else was a factor. At the Free Republic, I read a poster who said that the Fox Business channel was running live pictures of a street demonstration in Athens at the time of the plummet.
From a market-internals standpoint, it's easy to argue that a correction was overdue. The S&P was up more than 70% in the last fourteen months, and had veered to a somewhat overvalued level. In the jargon of the business, the market had "priced in perfection" with respect to recovery. Mark Hulbert reported on April 30th that NASDAQ-centered sentiment had reached a dangerous extreme of bullishness. Since people tend to be outspokenly bullish when they've already bought, a preponderance of bulls says that there's little buying power left. Moreover, short-term traders and advisors tend to be momentum-driven. Bullishness reaching an extreme often heralds equilibrating forces about to take the momentum away, or on the verge of turning it upside-down. Although they express it crudely, there is logic behind contrarians' insistence that the crowd is usually wrong when its members are close to being single-minded. As a postscript, Hulbert wrote subsequently that sentiment was satisfyingly plummeting after the Thursday rout. This reversal is encouraging because it bespeaks a lack of stubbornness in the bulls' camp, the kind that tends to accompany sustained declines.
Trading mistakes aside, the Grecian crisis was clearly the backdrop for the larger pullback last week. It isn't just French and German banks that have a lot of exposure to the European powder keg; American banks do too, albeit indirectly. According to Dick Bove, five of America's leading financial institutions – Bank of America, Citigroup, J.P. Morgan, Goldman Sachs, and Morgan Stanley - have more than $2 trillion exposure to Europe. Although the exposure to Grecian debt is insignificant-to-none (Bank of America) or none at all (the other four), their exposure to Europe means that they would suffer if a pan-European debt crisis erupted. [ pdf file here.] That's why the financials were hit especially hard last Thursday.
Some respected commentators have taken the Grecian government's fiscal crunch as a wake-up call for the United States. The former government's debt-to-GDP ratio is worse than the latter's, but not by very much.
Others have pointed to the states. The individual state governments are more comparable to Greece; like the Grecian government, they do not have the power to issue their own currency. Governments that do, and borrow primarily in their own currency, can devalue if necessary; in extremis, they can create new fiat money to pay back any threatening debts. Thanks to the now-known vulnerability of the fractional-reserve system, which can implode the money supply during a financial crisis, an adroit and lucky central banker could do so without causing significant inflation in the near term. The Federal Reserve's quantitative-easing program consisted of purchasing $400 billion in Treasuries and $1.2 trillion in mortgage-backed securities. Total U.S. government debt outstanding in foreign hands is $3.5 trillion. Granted, $1.6 trillion is less than half of that amount. But, if the Fed wanted to, it could have bought with that $1.6 trillion every single Treasury security in the hands of the Chinese and Japanese governments - and have some of the allocation left over. Printing money, if done adroitly in a deflationary environment, can whisk away a sovereign debt crisis. Deflationary storm clouds are not a sure thing in a sovereign-debt crunch, but recent events have shown that the panic-vulnerable fractional reserve system will likely implode if the U.S. does go through one. If so, it would provide the deflationistic backdrop for the Fed to launch a foreign-creditor-targeted quantitative easing program, with the inflationary potential of it bottled up like the current one is.
That option is not available to the Grecian government, as the Euro is trans-national, and it's not available to the states. Hence, Jamie Dimon's warning about the state of California being America's Greece. If there's any credit crunch coming to America, it would be in the muni bonds of states that went broke. That part of the bond market, not the U.S. Treasury market, is the one that's vulnerable to a crunch à la Greque. Any all-American sovereign debt crunch is more likely to take the form of corrosion through inflation.
Daniel M. Ryan is currently watching The Gold Bubble.
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