More Conundrums On the Way

By Duru

July 7, 2005

"Surprisingly calm investors pushed stocks modestly higher Thursday, helping Wall Street recover from steep early losses after the London terror attacks that killed at least 40 people and injured more than 700." These were the stunned words from a business writer at the Associated Press in an article titled "Dow Closes Up 32 Despite London Blasts" (by Michael J. Martinez; July 7, 2005). Indeed, business writers, pundits, and analysts all scrambled for explanations as to why buyers actually chose to add more stock to their portfolios instead of abandoning ship. These exercises to search for cause and effect always focus too much on the news of the specific day. In fact, if we were to use typical logic flexed in these exercises, we would have to say that the American financial markets ended positive because of the terrorist attacks. Certainly, if the markets fall tomorrow, these same logicians will fall back on terrorism fears as an explanation…despite the actual meaning of, say, tomorrow's job report. (Hmmm…maybe we could conclude that the market cares more about betting on a positive jobs report than the on-going damage and fall-out from the war on terrorism?!)

I know I am being a bit harsh since I am prone to the same kinds of search and effect, but at least I am not selective in my search to specifically boost my own opinion. Today's recovery was amazing to watch all things considered - the Dow moved up 127 points or 1.2% from the low to the close and the Nazz leapt 25 points or 1.2% from its low to close - so it might be interesting to continue examining the explanations out there in the ether before I offer up my own soliloquy:

"Investors took heart after the homeland security secretary said there was no 'specific credible evidence' of a pending attack in the United States." - Was there "credible evidence" of an attack on London before it happened? Nothing of the sort has been reported yet. In fact, the Brits are world renown for their vigilance, readiness, and security in their public transportation system. So what makes us think that we Americans are so special that we will be notified before terrorists decide to go on another barbaric mission here? The exact method and meaning of terrorism is to strike when your target least expects it; they intend to strike before being arrested or killed. I will assume that anyone buying stocks because of the homeland security secretary's reassurance will be promptly selling whatever they bought at the next slightest sign of trouble.

"A sharp drop in oil prices also helped the markets rally." - How convenient it was that oil prices dropped. You already know how I feel about this excuse. Given that oil is a strong and sustained up-trend, it seem futile to attribute market euphoria to a one-day decline within this up-trend. If you want to claim that the market is betting on a top in oil prices, I am willing to hear you out…before I dismiss that explanation too.

"Traders said the timing of the London attacks, several hours before the start of trading in New York, allowed investors to overcome any knee-jerk reactions to the news." - Were these the traders who wished they had sold their holdings yesterday? Would they please explain why the market opened down and preceded to sell off further before ending in the green?!? Which move was the true knee-jerk reaction?

"'Unfortunately, this is the world we live in now. Five years ago, the market would have been down much more. Now, we see it as a buying opportunity,' [Jay Suskind, head trader at Ryan Beck & Co. ] said. 'There's no panic.'" - Oh, I get it now. If the market had opened up much lower, we then would have gotten a knee-jerk reaction. The selling after 9/11 was also seen as a remarkable buying opportunity in the following two months. The NASDAQ, the S&P 500, and the Dow Jones Industrials are all hovering around the highs from that snapback rally. Almost four years later and we have gone nowhere. Imagine that… No matter what the reason is for selling, eventually, enough folks will see a buying opportunity that stems the downward slide. We saw the selling begetting buying pattern just last year after the Madrid bombings. Nothing new to see here folks. I do not even want to comment in detail on the appalling complacency expressed in this quote.

"Nonetheless, investors bought up bonds, always seen as a safer investment than stocks." - Uh oh. What's this? Not everyone saw the death and destruction in London and decided that it is time to bet on stocks? So, please tell us…are investors giddy, relieved, or scared? Who is the smart money and who represents the dumb money here? The article offers no observation or explanation on this more complex point.

"Gold prices, another traditional safe haven for investors, also rose." - You mean there was enough fear to even send gold up 0.26%? Wow, I am amazed - even as I check on the ETF "GLD" and note that after opening higher, gold seems to have quickly dipped into the red, before gradually recovering with the rest of the market. Now please explain THAT intra-day action!

"'American investors are not only reacting emotionally, they're trying to figure things out, trying to determine the economic impact of what happened,' said Ken Tower, chief market strategist for Schwab's CyberTrader. 'When you're not at the epicenter, that's easier to do. There were many more cooler heads outside of New York after 9/11, after all.' - You mean it is not emotional for the market to essentially change its assessment of such a large event from negative to positive in the span of 8 hours? You mean no one is trying to reassess the "risk premium" inherent in stocks now that these attacks have suddenly become more likely? I suppose I should conclude that the models that declare the global economy is better off when terrorists strike a foreign land (a close American ally no less!) won the day.

"'A certain amount of this is built in to the market,' Suskind said. 'And sad to say, when it's overseas and isn't targeting financial institutions, the markets can recover pretty quickly.'" - I suppose financial institutions can function just fine when the populace is paralyzed by fear. Perhaps they can operate without people at all. I must have missed that memo.

"In response to the attacks in London, investors sent biotechnology and biodefense shares higher….Airline stocks dropped sharply, however, as investors feared further terrorist attacks." - Finally something that makes intuitive sense. But if this kind of fear is already baked into the market, I suppose we should expect these trades to reverse mighty quickly. Stay tuned.

Now, before you think I am just a cynic throwing darts at easy targets, I will offer up my own thoughts for deconstruction.

As noted above, bond investors pulled the trigger on the safety play and bought up Treasuries today. This sent yields down and closer again to short-term rates. In tandem, housing stocks soared today. Several that I follow, like PHM, CTX, and LEN, hit or came close to 52-week highs. Add to this the fact that stocks rallied strongly and the dollar continues to look strong (sorry Warren Buffet!), you can get a picture of an economy that is doing just fine. In fact, I am betting the Fed looks at all this as further confirmation that the economy is quite healthy and fully capable of swallowing even higher rates. But if the markets now combine fear of an economic slowdown from an over-active Fed with a fear of heightened terrorist risks, long-term rates will continue to languish. This on-going failure to respond to the rise in short-term rates remains a troubling "conundrum" to the Federal Reserve. This conundrum is further highlighted by a stock market insisting on betting on sustained economic robustness while the bond market does the opposite…and now this plays out in the shadow of potentially growing geo-political risks.

Nevertheless, the Fed has proven to be persistent. It will continue to move to try to cool down perceived inflationary threats. Some folks are getting excited about a scenario where the Fed actually reverses course to lower rates in deference to these increased. Some European banks have already been lowering rates in response to a bleak economic outlook in the Eurozone (note how strong the dollar has gotten versus European currencies), but I highly doubt the Fed will get the rate cut bug anytime too soon…at least not under these current conditions. They have set their course and will remain more tuned in to strength than weakness.

All in all, these attacks have only strengthened the determination around the world to defeat terrorism. In fact, even the Egyptian president has declared a "war of annihilation" against terrorists as they have escalated attacks against Egyptian interests in Iraq. In my last missive, I claimed that Iraq has become a "brilliant" distraction to keep the terrorists occupied somewhere else outside of our own turf. That assessment was obviously poorly timed, but the scales of horror and terror still weigh heaviest in the Middle East. Regardless, one can almost feel the rising frustration, resentment, anger, and indignation around the world. Sure there is fear too. Sure all these emotions combine for one volatile cocktail that could escalate into blind fury. But the point is that this terrorism continues to prove as much pointless as it is barbaric. Nothing is getting resolved through this violence, and nothing will be resolved except for the world's resolve to seek and destroy those who seek out bloodsport. Let us not forget these are precarious times with no definitive endpoint or endgame in sight. It remains nearly impossible to price in these risks, much less assess the true scope of them, but we should also not use this as an excuse for complacency. Stay vigilant, and, as always, be careful out there!

© DrDuru, 2005