One of the things shaking today’s market is again problems in Europe. There were some reports that Societe Generale, the second largest bank in France, was in trouble. Later some of these reports were retracted. Over the last couple of days there have also been reports that US bank regulators have been asking US banks to reduce dealings with the European financial system. The current sell off is starting to remind me of 2008 where there was high level of uncertainty about the financial system and it was hard to trust any information.
Under such a scenario it is very hard to trade as it is really hard to figure out why the market is moving. I have drastically cut back on the position size for my trades. This might be a good time for investors to start stepping in and buying companies which have good balance sheets and are globally diversified. In the long run stocks will always revert back to valuing companies based on their earnings potential.
Based on the nature of the market drop and parsing the information from last few weeks here are what I think are the main reasons for the sell off over the last two weeks. They are listed in the order of importance.
- European sovereign crisis and fear of insolvencies in major European banks. I think this is by far the most significant reason. The speed of the sell off and the rapid increase in safety assets like treasuries, gold and the swiss franc is an indication this was a more of a financial panic not a market pricing in a slowing economy. Especially the rapid rise in gold and the Swiss franc is an indication this was a fear trade due to a possible financial crisis. Especially the moves in interest rates and gold are pretty contradictory. A drop in rates indicates lower inflation whereas gold is used as a inflation hedge. You get these type of contradictory moves only when there is fear of a financial crisis.
- Forces of austerity winning in Washington. I think after the debt limit talk it became clear that the forces of austerity are winning in Washington and there would be very little from fiscal policy which could help the economy. If the economy goes into a recession there will be very little will in congress to do something about it.
- Lack of compromise and political dysfunction. Washington did not even do austerity very well. Due to lack of compromise on revenue increases and entitlement reforms even the deficit reduction package was not bold enough and did not include ideas like simplifying the tax code and cutting loopholes which are reasonably popular on both sides of the aisle. Political dysfunction was one of the factors cited in the S&P downgrade of US credit rating.