The Equities Markets Recent Turmoil

The business media is all a buzz with the biggest equity market news in years. A 3.5% drop in the S&P on Tuesday has everyone scrambling to discern whether this is a "corrective" phase in the equity markets, or the beginning of the dreaded "crash."

So, which is it? Well, I confess to being no seer of the future of the equity markets. But I can offer some observations on the past and current situations.

It's important to recall that, over the long term, equity market troubles inevitably reflect real economic issues.

For instance, in October, 1987, it was my alma mater, the Chase Manhattan Bank's refusal to back the United Airlines ESOP loan, that triggered Black Monday, on which the S&P fell 20.5% by that day's end. This called into question the overall credit expansion, and resulted in market turmoil for several months thereafter. But that single month was the one really bad one for equities.

The Asian debt crisis of 1997 had little effect on US equity markets, but crippled Asia for some time.

In 1998, Long Term Capital's demise resulted in a 14.4% loss for the S&P in August. However, with no actual real economy basis for this incident, the market recovered within only a few months.

With those incidents as background, we need to identify what would be current sources of weakness and shock to the current economic situation in the US, or around the world. From watching CNBC and reading the Wall Street Journal this week, I confess to not finding the smoking gun which would make the volatility of the past few days into the equity markets expression of a looming economic catastrophe.

Let's consider the most frequently named culprits: sub-prime mortgage lending, Asian equity markets, US and global economic growth, excess liquidity, hedge fund excesses.

As far as I can tell, the sub-prime lending troubles do not constitute the bulk of mortgage lending. True, lending standards are tightening again, which will lead to a continued pacing of any residential real estate sector recovery. But is sub-prime lending going to trigger a recession? From what I have read and heard, it's doubtful. Some companies will go bankrupt, and some homes will go empty for a while. But I don't think it will, on its own, tip the US economy into recession. If anything, it might lead to a quarter point rate cut by the Fed by the fall of this year.

The Asian equity market's 9% decline earlier this week was apparently more of a reaction to a similar runup in prices over the prior six trading days. There seems to be no visible, underlying economic weakness which triggered the decline. Chalk it up to short-term market froth in Asia.

While recent GDP adjustments have trimmed growth from 3.3% to 2.2%, the economy is still growing. Even given Samuelson's accelerator/multiplier effect, we should only see a slowing of overall economic activity, not an outright, longer-term decline or recession. There are some focused sectors of weakness- Detroit, for auto production, and selected real estate markets around the US- but overall economic activity remains strong, with low inflation. Even today's manufacturing report is positive.

Every spring for the past two calendar years, a legion of second- and third-tier economists have attempted to make their names by forecasting a "soft patch" or a recession, only to be proven wrong by fall of that year. It looks like 2007 is shaping up similarly.

While I'm tiring of his using it relentlessly, Larry Kudlow is right when he asserts, continuously, that this economic expansion is "the greatest story never told." As such, global economic growth seems to be keeping pace with the US.

The liquidity issue may affect equity markets if, in fact, as Doug Cass, of Seabreeze Partners, alleges, much of current hedge fund capital is, in fact, leveraged on the way in. If this is true, and recent performance weakness leads to large redemptions by European institutional investors of mostly-borrowed money, then US equity market prices might decline in the face of reduced supply of funds. That probably won't change relative values, though. And it might not even affect the market for much more than a few months. It's simply unknown what the size of such investments might actually be.

Consider that the US equity market. According to IMF data, it was roughly $11 trillion in 2004. If a hedge fund like SAC has even $40B under management, it accounts for less than .50% of the equity market. So the effect which Cass mentions may not be all that important.

Similarly, hedge fund losses would certainly affect prices. But it's somewhat of a chicken and egg issue. If the funds lose money because prices fall, do prices fall further because the hedge funds lost money? That's not clear, either. Certainly, the more risk averse retail investors may be running to the sidelines right now. But the cooler-headed professional investors are not.

Overall, I don't see the pundits I tend to trust- John Rutledge, Arthur Laffer, Larry Kudlow, Brian Wesbury- running for cover or sounding alarms. They all feel that, if anything, the current market represents a buying opportunity.