Caution in the Market

You see, I shouldn’t nose around on I have no business there (pun intended). I found this article from today that says just the opposite of what everyone else was saying.


Investors are breathing a sigh of relief as Wednesday’s stock market rebound wiped away some of the pain inflicted by Tuesday’s tumble. They would do well to stay very scared.

Whether Tuesday’s route turns out to be a turning point or a blip, it is an indication of just how edgy investors around the globe have become. With good reason.

The U.S. stock market, by far the world’s largest, has been on a bull run for four years without a major pullback. While the S&P 500 is nowhere nearly as expensive as it was in the late 1990s, neither is it cheap at about 17.6 times the latest 12-months’ earnings. That is near its historical average at a time when profit growth is slowing.

With little margin for error, there is plenty of cause to fret. The housing market, for one, is looking increasingly shaky. Defaults of subprime mortgages are already rising, and Wednesday’s announcement of a 16.6% fall in new home sales in January represents the largest monthly drop in 13 years.

These trends are worrisome for two reasons. Housing has been a key driver of economic activity in the economy the past few years. In addition, banks, brokerages and big investors are holding hundreds of billions of dollars worth of real estate-linked debt and derivatives. The knock-off effects of a meltdown are unknown but sure to be massive.

With investors so skittish, one big danger is that a prolonged market drop will quickly set off a credit crunch, as yesterday’s flight to treasuries presaged. A credit tightening, in turn, could cause a jump in junk bond and other defaults, a plunge in M&A activity and a surge in corporate and personal bankruptcies.

Overseas, things look just as precarious. Emerging market stocks and bonds in particular have been on a tear that has left them vulnerable to the sorts of collapses they have suffered in the past. Signs of weakness could also prompt hedge funds and other big investors to unwind their “carry trade” positions, selling Chinese and other emerging market assets and converting them back into yen, which they’d borrowed at low interest rates. Demand for the Japanese currency would in turn put selling pressure on the dollar and U.S. assets.

With yields on junk bonds now little higher than those for U.S. treasuries, $1.5 trillion in hedge fund money sloshing unregulated around the globe and derivatives markets linking it all together in ways nobody fully understands, one thing is for certain: A serious bout of bear market pain could spread far and fast–leaving very few investors unscathed.

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Errington C. Thompson, MD

Dr. Thompson is a surgeon, scholar, full-time sports fan and part-time political activist. He is active in a number of community projects and initiatives. Through medicine, he strives to improve the physical health of all he treats.


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