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Wall Street takes profits to avoid bubble

Wall Street
Wall Street
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Nervous investors watched the Dow Jones Industrials plummet 318 points or 2% today in the biggest one-day sell-off since June 20, 2013, when the DJIA tumbled 353 points or 2.3%. Back in June, markets reacted to Fed President Ben. S. Bernanke hinting that he’s considers “tapering” the Fed’s bond-buying program known as QE3. When Bernanke eventually announced Dec. 18, 2013 he’d start tapering, the DJIA rocketed upward setting a new record Dec. 31. After setting a record high Dec. 31, 2013 at 16,576 and peaking again Jan. 15 at 16,482, the DJIA is off around 5%, nothing compared to the freefall after Oct. 9, 2007 when the average peaked at 14,164 eventually hitting bottom March 6, 2009 at 6,443 or off 55%. What’s different today is not the expected slowdown in China or emerging markets but pure profit-taking by the nation’s biggest funds riding one of the biggest bull markets in U.S. history.

Dumping baskets of stocks, Wall Street’s arbitragers, or short-term sellers, decided to lighten up portfolios hoping to take share prices down to more affordable levels. Losing 3.5% for the week says little about the current sell-off that’s been predicted by practically everyone since hitting the recent peak Jan. 15 of 14,482. Proving that the sell-off’s profit-taking, the broad-based S&P 500 slipped 38 points or 2.1% with the Tech-rich Nasdaq dropping 91 points or 2.2%. When all indexes match the same percentages it indicates the sell-off was broad-based, not related to the news about China or emerging markets. “There’s a lack of buyers supporting the market and incremental sellers who are de-risking on the back of the macro developments,” said Doug Crofton, head of cash equity trading for Bank of America’s Merrill Lynch, finding external excuses for the sell-off.

With Bernanke handing the reigns to new Fed Chairman Janet Yellen Jan. 31, there are few worries that U.S. monetary policy will change anytime soon. If Yellen sees a threat to U.S. Gross Domestic Product, she’d push back the expected tapering of $10 billion a month. “I don’t think the market was positioned for the recent events,” said Crofton, realizing that whatever happens in Asia doesn’t affect Wall Street or mighty U.S. economy. Taking profits is part of Wall Street's natural cycle, often attributed to domestic or foreign economic events. While macroeconomic issues, like the 2000 dot-com bubble or 2007 real estate bubble cause bigger sell-offs, markets must eventually adjust for inflated prices. Yale economics professor and recent Nobel laureate Robert Shiller warned markets December 2, 2013 that his Cyclically-Adjusted Price Earnings Ratio suggested a new market bubble.

Shiller and other market bears’ predictions, like perennial bear New York University Stern School economist Nouriel Roubini, didn’t stop the DJIA and other market indexes from hitting new peaks by Dec. 31, 2013 or Jan. 15. It’s not rocket science when economists, after watching markets climb nearly 60% from the March 9, 2009 lows, to predict market corrections. Sooner or later, what goes up must go down, or, more importantly for savvy investors, what goes down must come up. When Crofton talks of a “lack of buyers,” he’s referring to value investors scared off by today’s inflated share prices. Shiller’s calculations have to do with PE ratios getting so far out-of-whack that share prices become unaffordable, especially to savvy investors. When earnings don’t match inflated PE ratios, it triggers profit-taking by large mutual, private equity and hedge funds, looking for more business.

When you look at the sell-off in Asia with Japan’s Nikkei dropping 1.9%, Hong Kong’s Hang-Seng 1.2% but China’s Shanghai Composite rising 0.6%, it suggests Asia takes the sell-off less seriously than Wall Street. If real macroeconomic issues plagued Asian markets, they’d drop far more than U.S. markets. “We’re seeing funds thinking, ‘there’s clearly some macro risk I hadn’t considered,’” said Ian Winer, director of equity trading at Los Angeles-based Wedbush Securities. “You’ll sell stocks to bring down your overall exposure, so you’ll protect yourself to play another day. We’re seeing funds do that,” giving investors reason to dump stocks. What Winer doesn’t say is that profit-taking and market corrections are necessary to keep a bull market moving forward. When PE ratios get out-of-whack, as Shiller says, it stops savvy fund investors from buying at inflated prices.

Market psychology can turn from mild anxiety to outright panic, causing the current slide to accelerate. When short-selling hedge and private equity funds start profit-taking on the downturn, things can go from bad to worse. Apart from minor glitches in Asian markets, there’s no macroeconomic reason for Wall Street’s current sell-off other than profit-taking. If there were real problems in China and emerging markets, their stock markets would sell-off more than Wall Street. What happens to Turkish lira or South African rand has nothing to do with what happens on Wall Street. Funds sell stocks and go into money markets when they plan to buy back shares at discounted prices. Watching the DJIA, Nasdaq and S&P hit record highs signals that it’s time for profit-taking no matter what the national or global economic picture. After funds wring out the markets, look for another big rally.

About the Author

John M. Curtis writes politically neutral commentary analyzing spin in global and national news. He’s editor of and author of Dodging The Bullet and Operation Charisma.

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