In the past few weeks, daily triple-digit moves in the Dow Jones industrials have become unusually common. And the moves have not been in one direction. Instead, the roller-coaster ride has included a 4.1 percent fall between Nov. 13 and 23, followed by a 6.4 percent surge since then (as of Dec. 12). No wonder analysts have fluctuated between predicting prolonged market weakness and a sharp recovery.
In trying to make sense of such market conditions, I employ a tool that I learned from Bill Gross, whom I will be joining shortly at Pimco. Widely respected for his consistently superior investment results (which earned him the title of “bond king”), Bill advises investors to distinguish between what they know and what they know they don’t know.
The markets right now know that the financial industry is in the midst of dealing with a hangover after several years of excessive risk-taking. This is most vividly illustrated by the massive losses at banks like Citigroup, Merrill Lynch and UBS.
The markets know that the fallout from this could affect the real economy. This is particularly the case in the United States, where the crisis in the subprime segment has slowed housing activity, wounded builders and suppliers, and hurt mortgage companies. The prospect of large foreclosures adds to concerns about further falls in home prices, faltering consumer confidence and high oil prices.
The markets also know that the immediate reaction of regulators is, inadvertently, to amplify the risk of a credit crunch. They tighten standards to protect consumers from the negative consequences of additional lax lending. But in doing so, they risk undermining the overall flow of credit, as lenders themselves retreat to lick their wounds.
The markets know that all this is coming at a fragile time for the U.S. economy. The country has been running sizable deficits and relying on financial flows from abroad; hence the recent weakness in the dollar.
Finally, the markets know that the markets’ traditional “automatic” stabilizers are less effective today given the rise of more-opaque investment vehicles like complex structured products. The lack of transparency undermines fair pricing and inhibits buyers and sellers from interacting directly—which is also undercutting trust among the banks themselves.
All this bad news is offset by the recognition that there are possible sources of help on the way. The problem is that market players can’t be sure they know these compensating forces will work under the current conditions.
For example, the markets know that central banks around the world are willing to inject liquidity, especially when it comes to interbank activities. Indeed, this week the U.S. Federal Reserve announced additional measures that involve explicit cooperation with other central banks. Yet the markets do not know whether this enhanced liquidity will find its way quickly to where it is needed most.
The markets know that the Bush administration is looking for ways to directly support the housing sector and forestall a new wave of foreclosures. They do not know how the plan will be reconciled with the sanctity of contracts that is so crucial for well-functioning capital markets.
The markets also know that there are new investors from the developing world waiting to buy up cheap assets as long-term investments. Indeed, last week’s announcement that ADIA, the investment arm of the Abu Dhabi government, will buy a 4.9 percent stake in Citigroup helped the company’s stock surge almost 12 percent in just four days, and a further 4 percent in the following week. This was followed by a capital injection for UBS, led by Singapore. But markets do not know whether these funds will face a protectionist counterforce.
Finally, the markets know that the emerging world in particular is relatively well positioned to decouple from the weakening U.S. economy. But they do not know whether the decoupling forces are strong enough to withstand another round of global financial dislocations.
This tug of war between what markets know and what they know they do not know means that investors should fasten their seat belts in anticipation of further volatility. The key point is not to overreact to every bit of new information or each new twist in stock-market valuations. Instead, investors should be anchored by a diversified asset allocation, including sufficient cash reserves and “safe assets” to avoid being a distressed seller at precisely the wrong time. Most investors should leave the high-frequency stock trading to those who either possess very sophisticated tools or are simply too foolish to realize what they are doing.
