Smoke or Fog?

Since the beginning of July global stock markets have been self-immolating using the fires of fear.  A little bit of uncertainty and bad news was tinder for outright panic on many trading days.  In fact, since the 7 July, 2011 peak the S&P 500 has fallen 16.95% as of yesterday’s close.

Unfortunately, all of that selling created a lot of smoke; smoke that obscured the actual real news of the U.S. and global economy. In short, no one was paying attention to the facts of the situation.  So has the smoke cleared?  And have the fires stopped?

I feel that the fear fires have nearly burned themselves out.  There remains a palpable sense of nervousness on the part of many investors.  But those who were motivated to act on bad news seems to have acted already.  Instead, what is left is not smoke, but fog.  What does that mean?

It means that the fear has given way to obscurity.  No one is really sure what the grand effect will be from all of the selling that took place over the past two months.  Will the economy ride it out?  Are consumers going to alter their behavior based on the panicked selling of large institutional investors?  Have businesses gotten cold feet and started avoiding growth mode and re-entered self-protection mode?  Has the U.S. government loosened its political gridlock?  Have the Europeans staved off their debt woes?  And so forth.

There are a lot of unanswered questions currently; questions that can only be answered with data.  But this is substantially different than panic selling.  Emotions have been replaced by a willingness, not to act on innuendo, but a reflective moment.  That means that outright irrationality has given way to increased rationality.

Ideally stock market investing responds to the news of the day, not the fear flavor of the month.  And that seems to be where we are right now: wait and see.  Wait for the data then act.  Don’t read these comments incorrectly as fear is still the predominate mood.  If the economic and business data of the next several weeks is negative expect more panic fires and more smoke.  If the economic and business data is positive, especially surprisingly positive, then expect an even bigger shift from fear to consolidating rationality.

I have given several radio interviews over the past several weeks and the general tone from the general public seems to be one of fears of a proportion smaller than that of the professional investors.  Even more importantly, I sense more confusion, outrage and disinterest than I do fear.  This latter category – disinterest – is exactly what I hope for the financial markets going forward.

As I have written about before the Great Depression created an inaccurate mythology: a stock market crash is what caused the Great Depression.  Unfortunately, this bit of bull has ingrained itself on the collective consciousness of the First World.  Consequently the public views the rise and fall of equity values as an indication as to the health of the economy.  To some extent this is true.

However, most trades these days are executed based on sophisticated computer algorithms that instantaneously calculate a response to the flow of other traders’ calculations and responses.  In other words, financial markets experience shocking volatility, not driven by news, but more by volatility itself.

Enter a few fearful institutional investors at the margin and momentum becomes tsunami.  This is why small trading volumes can generate such wild swings in total value.

In other words, it’s been a long time since the day’s trading volume was a truly accurate reflection of the underlying economy.  Instead most trading is a reflection of the momentum already present.  This is especially true when there is a lack of economic data to create a motive force behind the momentum.  Remove the marginal trader responding to fear and the markets tend to go sideways.

In conclusion, we are awaiting the next motive force: real economic news – that will determine all the rest.  We have moved from fires of fear to the fog of data obscurity.

Jason