The Real Reason for the Aug. 4 Sell-Off

Money Morning Investing Article of the Week

By Shah Gilani, Contributing Editor, Money Morning

On Aug. 11, 2010, the Dow Jones Industrial Average plunged 265 points, or 2.5%.

Last Tuesday (Aug. 1) – almost exactly one year later – the Dow dropped … 265 points.

Those carbon-copy stock-market sell-offs weren’t a coincidence. – as last Thursday’s 512-point drop and further weakness will prove.
Although the Dow is more than 700 points higher than it was at this time a year ago, U.S. stock prices are currently following virtually the same trading pattern that they did in 2010: Last year and again so far this year the early-year gains came to a halt in May, and the markets then fell through August.

But here’s where the story gets scary.

Last year, the U.S. Federal Reserve halted the stock market’s summer swoon by opting for a second round of quantitative easing – an initiative most of us refer to as “QE2.”

A year later, even after a week heavy with stock-market sell-offs, there’s no guarantee we’ll see another Fed rescue mission. And this time around, without a massive injection of quantitative easing – the much-ballyhooed QE3 – it could finally be all over for the stock market.

Where the Stimulus Really Went

Stocks have endured a real beating in recent days – yesterday’s stock market sell-off was the worst one-day plunge in U.S. stock prices since December 2008.

When the Dow plunged 265 points on Tuesday, it was because of an unexpectedly large drop in the Institute for Supply Management’s (ISM) Purchasing Manager’s Index (PMI). The 265-point August 2010 sell-off was precipitated by the U.S. Federal Reserve’s negative outlook on the American economy.

But both the August sell-offs were preceded by strong run-ups in stock prices. Those run-ups weren’t sparked by an improved economic outlook – which is how it usually works.

Instead, the bull market that powered U.S. stocks off their March 2009 bear-market lows was the result of the massive monetary stimulus put in place by Washington and the U.S. Federal Reserve.

The U.S. monetary stimulus – billions of dollars worth- went into banks and other financial institutions – and not into the economy.

That’s why stocks have benefited – even in the face of an economy in which growth has been lackluster, if not downright flat.

Generally, stock prices are a reflection of corporate profitability. Sometimes rising stock prices lead economic activity and sometimes price appreciation trails economic growth. But historically, stock prices don’t rise if the economy isn’t growing.

This time around, however, there was a “trickle-down” benefit that boosted stocks, but bypassed the economy.

The monetary stimulus trickled down from banks, where it was initially injected, onto corporate balance sheets. From there, thanks to a weakened U.S. dollar, the stimulus enhanced export-driven corporate profitability.

Lest you think this occurred by happenstance, let me assure you: This all happened by design.

The Ugly Truth About the American Banking System

Most U.S. banks were in dire straights and all of the too-big-to-fail banks (the largest banks in the U.S.) were insolvent as a result of the credit crisis that hit in 2008. Both the U.S. Treasury Department and the Federal Reserve (which is run by bankers, essentially for banks) recognized that they had to save the banks at any and all costs – otherwise the U.S. economy and the global economy would collapse into a depression of catastrophic proportions.

Money was pumped into the financial system by means of several government and Federal Reserve programs. Interest rates were kept so low that the overnight rate that banks charge each other, which is engineered by the Federal Reserve Bank of New York, was, and still is, at historic lows in the range of 0.00% to 0.25%.

With money borrowed at essentially no cost, banks bought risk-free U.S. Treasuries. The banks used the Treasuries they bought as collateral to borrow more money in the short-term “repo” markets. And with those additional borrowed funds, the banks bought even more Treasuries.

The interest that the banks collect on the Treasuries (which you and I as taxpayers are essentially paying) created a profitable “interest-rate spread” – the difference between the interest they earned on the bonds they held and the almost-interest-free “loans” they took out in order to leverage their balance sheets.

Banks play a key role in the U.S. economy. By lending money to the private sector, they make it possible for new companies to be formed and existing ones to grow – all of which creates jobs and helps the economy grow.

But banks aren’t lending to the public. Why should they? They make good, safe money on a risk-free basis running the Treasury-spread trade.

Besides, U.S. credit demand has been anemic.

Corporate America Joins the Party

Because interest rates are being held down at artificially low levels, corporations also turned to the bond market to borrow cheaply. In such a low-rate environment, fixed-income investors were forced to scramble for any additional yield they could get above that of U.S. Treasuries – meaning they were only too happy to oblige corporations by lending them money.

Corporate America was able to quickly retool its collective balance sheet, and now sits on about $2 trillion in “cash equivalents” – Treasury bills that companies use to make sure that they collect at least a tiny bit of interest.

The key direct consequence of this massive monetary stimulus has been a weak U.S. dollar. As the dollar falls in value, it makes U.S. exports cheaper on global markets.

That’s why corporations with healthy balance sheets and substantial overseas sales have been reporting great earnings. And it’s also why these corporate heavyweights – and many mid-sized companies, besides – have enjoyed a nice run-up in their share prices.

It doesn’t end there, either. When such strong stock-price gains are posted in a couple of sectors, investors turn to “underperforming” sectors to ferret out bargains, hoping to get in ahead of the inevitable share-price rebounds that result from the money that floods in after investors “rotate” out of fully priced stocks into their undervalued brethren.

One Long Stock-Market Sell-Off?

The bottom line is that the stock and bond markets have been big beneficiaries of the trickle-down policies of the Fed and the Treasury. This is exactly what Fed Chairman Ben S. Bernanke said he wanted to see happen in order to stem the threat of deflation. It has been an articulated policy (except for any admission that they wanted to knock the dollar down – which, of course, they knew would happen).

That brings us to the state of the U.S. economy.

By this time you’ve no doubt heard the term “The New Normal.”

The New Normal – as espoused by PIMCO‘s Mohamed A. El-Erian – is pictured as an American economy with a chronically anemic growth rate of 1.0% to 2.5%, and structural unemployment in the 8% to 9% range.

It’s not a pretty picture.

Already this year, first-quarter gross-domestic-product (GDP) growth was adjusted from an initial estimate of 1.9% all the way down to 0.4%. The second-quarter number just came in at 1.3% –well below the 1.9% rate analysts had been expecting.

It’s not just the GDP numbers that have been all over the place and slipping dangerously. Many other economic indicators and data points are turning down.

Investor sentiment and consumer confidence are at multiyear lows. Unemployment remains stubbornly high and is likely to rise. Private-sector employment has been horrible and new deficit-reduction plans will lead to reductions in government spending and layoffs in the historically stable government-jobs sector.

It’s no wonder, then, that when the Purchasing Manager’s Index came out on Tuesday at 50.9% (its lowest level since October 2008, and its first contraction since June 2009), already-skittish markets plunged. And they’ve continued to fall – as we saw with yesterday’s 4.78% plunge in the Standard & Poor’s 500 Index and 4.31% dive in the Dow.

Just like last August, if the economy continues to falter, the markets will pay more attention to economic reports than to company-earnings reports – no matter how good those earnings reports might be.

And unless we get another round of stimulus – in whatever form we’re able to get it – the aborted stock-market sell-off of last August will come home to roost today.

As this week’s stock-market sell-off underscores, last summer’s QE2 rescue mission has only postponed the inevitable.

Investors better be defensive. The financial markets have been long overdue for a major correction. And without some new stimulus that actually makes sense for the economy – and doesn’t just pump up asset prices – the protracted stock-market sell-off that will carry us through autumn will forever be remembered as “The Fall.”

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