To an extent not fully appreciated by the investing public, financial markets are influenced by human emotion just as much as they are by economic data, corporate earnings, and dividend yields. Of all human motivations, fear is perhaps the most powerful. When people get scared, the "fight or flight" instinct forces us to take action.
Simple dangers prompt simple responses. If we unexpectedly encounter a bear on our driveway, we immediately run into the house and call animal control (or, in the country, grab the shotgun). But it's harder to know what to do when financial danger stalks the stock market. To be honest, most investors are clueless. Is that really a bear? Is it dangerous? What qualifies as a house?
When confronted with fear AND confusion, investors tend to look around to see what other people are doing - hoping that others know something they don't. This is a big part of our natural and instinctive drive to seek safety in numbers. When financial markets panic, investors follow the herd. If the herd does something illogical, like buying US Treasuries when they pay almost no yield and when the government is essentially bankrupt, it is evidence that people have decided to seek safety in numbers.
But here's the thing: this herd doesn't have a leader. As much as we would like to think that there are rational, or sinister, individuals who decide where the herd goes and how fast it will take to get there, in reality, we just have a center of gravity around which the herd coalesces. Individuals may make an impact but the mass has a mind of its own. The center of gravity does move, but it tends to do so glacially.
As a result, we can expect that market movements in the current correction will largely resemble past corrections. However, there will be slight differences, which should be studied intently to determine where the center of gravity is drifting. It's particularly important to notice where the herd is seeking safety.
Yesterday's sell-off in the US markets saw the the S&P 500 lose 4.8% of its value. The Dow's loss was, at 513 points, the biggest one day drop since December 2008. It capped a horrific 10-day plunge that knocked more than 10% off stock prices overall.
The carnage has many investors queasily recalling the nightmare days of the credit crunch of 2008. In one particularly brutal phase of that crisis, between December 16, 2008 and March 9, 2009, the S&P 500 sold off more than 25%. Fear drove investors to seek safety in traditional havens. During that time, the US dollar rallied by 8.4% while foreign currencies sold off heavily, including a 9% dip in the Australian dollar and a 3% haircut for the vaunted Swiss franc. Gold rallied 7.4% during that period, but failed to beat the dollar's run up.
The next major correction in stocks showed a slightly different result. Between April 23, 2010 and July 2, 2010, the S&P 500 dropped 16%. During that time, the dollar rallied just 3%. Notably, this time around, the Swiss franc did not sell off, but rather rallied by about 1%. More importantly, gold rallied nearly 5%, taking from the US dollar the title of "fear asset of choice."
These trends have gained momentum in the current sell-off. From April 29, 2011 to August 4, 2011, the S&P 500 lost 11.3%. During that time, the dollar managed just a skimpy .3% gain. Meanwhile, the Swiss franc jumped almost 13% and gold surged 5.6%. It does appear that the crowd has changed at least some of its assumptions. It no longer runs blindly into US dollars. It considers other options.
There are many theories as to what moves the herd's center of gravity. Here, I don't think it's much of surprise. Since 2008, a steady drip of news stories have highlighted the staggering indebtedness of the US government, the unwillingness of its policymakers to confront the crisis, and the stubborn persistence of economic stagnation in the face of growing inflation. Although the dollar is still regarded as a place to go when the going gets rough, that opinion is not as strong as it was in the days before our economy imploded and our government became the economy itself.
I would expect the broad trends outlined here to continue. As economic data continues to disappoint, look for the stock market to continue to fall. If the drop goes too far too fast, look for an early launch of the next round of quantitative easing. QE3 may help stabilize stock prices, but it will further erode confidence in the US dollar. As a result, when the next panic hits, look for the dollar to perform that much worse than it did this time around.
Although the dollar's doom is clearly written on the walls, the center of gravity in the financial world has moved very slowly and will likely continue to do so. Fortunately, for our readers, the direction of the movement is clear. Thus, we are positioned well in front while Wall Street brings up the rear.
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