Recent Stock Rebound a ‘Correlation’ Breakup
The U.S. stock market’s turnaround in the last three weeks may have happened just in the nick of time--not only for the typical mutual fund investor, but for the global financial system overall.
Some Wall Street veterans say the market’s meltdown in June and July was threatening to cause a major financial accident, or perhaps a number of them, among big institutional investors. Some say that risk still is there, if less severe for the moment.
This kind of talk isn’t unusual when markets are in disarray. But as the near collapse of giant hedge fund Long Term Capital Management in September 1998 demonstrated, it often isn’t just talk: Extraordinary losses in markets naturally increase the risk of extraordinary failures.
Investors’ fear of a devastating financial explosion may have been most apparent in the shares of the two largest U.S. banks, Citigroup Inc. and J.P. Morgan Chase & Co. The stocks were in a freefall July 22 and 23. Morgan’s shares dropped 23% in those two days, bringing their total decline from June 28 to 40%--wiping out $27.5 billion in market value.
Exactly what frightened investors into dumping the stocks with such intensity can’t be quantified, of course. Every investor has a reason for selling. But James Bianco, head of market research firm Bianco Research in Chicago, believes that one message in the bank stocks’ plunge, and in the dive in stocks in general last month, was that the risk of financial accidents was mounting.
“I think stocks were pricing in the risk of a financial crisis,” Bianco said. “That doesn’t mean there is one,” he said. The problem, however, is that “if the markets believe it enough, they can make it happen.”
For the financial system, the trouble in June and July wasn’t simply the U.S. stock market’s slump. It was that Wall Street’s decline was wreaking havoc with so many other markets.
For many investors, that meant there was almost nowhere to hide. Red ink was rising throughout their portfolios, in turn deepening the crisis of confidence in markets and in the financial system itself.
In the parlance of the money management business, the issue was one of “correlation”--the degree to which markets move in the same direction.
Big investors create diversified portfolios specifically to avoid the potential for gross correlation. They want some investments to be zigging when others are zagging, thus reducing the threat of severe losses to the portfolio overall.
But from mid-May to late July, markets worldwide were moving in stunning correlation with the U.S. blue-chip Standard & Poor’s 500 index, Bianco and other analysts say.
“The correlations were huge,” said Tom Sowanick, senior fixed-income research chief at Merrill Lynch & Co. in New York.
That was more of a surprise because it was a sharp reversal of what happened in the first four months of the year. In that period, the S&P; 500 and the Nasdaq composite index were sinking, but many other sectors of the U.S. market were rallying, as were many foreign markets.
By contrast, between mid-May and July 23, nearly every sector of the U.S. market gave ground. So did most foreign markets.
More troubling for diversified portfolio managers was how other financial sectors were crumbling, including most lower-quality corporate bonds and even some higher-quality issues.
Meanwhile, the dollar’s value was dropping, and the price of gold was virtually flat, offering no significant offset to the global disaster in equities.
Besides short-term cash accounts, there was one safe haven between May and July: U.S. Treasury securities. For those investors who owned them, Treasuries worked beautifully to partially offset losses elsewhere in a portfolio, as market yields fell and the value of the bonds rose.
But even that was a correlation, of sorts, with the S&P; 500--a surprisingly strong inverse correlation.
Few investors had bet that Treasuries would rally to the extent they did, pushing yields on some of the securities to generational lows. Hedge funds and others that had “shorted” Treasuries, believing that yields couldn’t go any lower, would have been hammered.
The last time correlations were improbably high among financial instruments was in August and September 1998, when the Russian debt crisis triggered sell-offs in markets worldwide.
The hedge fund Long Term Capital Management, which in 1998 made massive bets on bonds using borrowed money, found itself dealing with a portfolio plunge that none of its computer models had predicted. Those models assumed that the level of correlation occurring in markets was practically impossible. Yet it was happening.
As one banking regulator put it at the time: “The LTCM risk model told them that the loss they incurred on one day at the end of August 1998 should have occurred once every 80 trillion years. It happened again the following week.”
The failure of Long Term Capital Management, which owed billions of dollars to some of the world’s biggest banks, could have set off a chain reaction of failures within the global financial system. Facing that prospect, the Federal Reserve quickly acted to cut short-term interest rates in September 1998, and brokered a bailout of the hedge fund by leading banks and investment firms.
Fast forward to the present: On some levels, especially with regard to stocks, the losses investors suffered in recent months have been far worse than what they lost in late-summer 1998.
As the losses in July deepened, they may have fed on themselves as investors saw the downward spiral as threatening a financial accident on the scale of Long Term Capital Management. As Bianco put it, investors were in danger of making sure their worst nightmare would be fulfilled, as fear of that nightmare fueled more selling.
But since bottoming July 23, U.S. stocks have bounced. The S&P; 500 last week gained 5.1%, its third straight weekly advance. Other markets worldwide also have stabilized, and the dollar’s value has rebounded somewhat.
Did the global financial system dodge a bullet, or was there no material threat of a crisis this time?
Some Wall Street pros argue that big banks and investment banks learned important lessons about risk from the Long Term Capital Management affair. Those lessons may have lowered the threat to the system this time around, even as market correlations became intense, some say.
“Professional investors learned to keep within more reasonable risk limits,” said Ethan Harris, co-chief economist at Lehman Bros. in New York. In particular, use of leverage may be more restrained.
Others say the pain of market losses this time has been spread more broadly among investors, diffusing the risks rather than concentrating them.
Another argument is that the oft-maligned “derivatives” market--over-the-counter financial contracts that big investors use to hedge risks with one another--is working the way it should to protect portfolios from volatility.
Bill Fleckenstein, a Seattle money manager who routinely shorts stocks, betting on lower prices, said he has been puzzled as to why no large portfolio blow-ups have occurred in recent months, given the markets’ swings.
“Maybe the derivatives are well-structured,” Fleckenstein said. “Maybe it’s all going to hang together better than we thought.”
But if the stock market’s turnaround has lessened the chances of a financial crisis developing, the question then becomes: What if markets begin to unravel again?
That possibility puts more pressure on the Federal Reserve. Many investors expect the Fed to cut interest rates again, if not at this week’s meeting, then in the fall.
With its key rate at a 40-year low of 1.75%, however, the Fed is nearly out of ammo if a full-blown financial crisis were to occur.
What troubles some experts is that bear markets of the current one’s severity have always had a nasty habit of taking down one or more big players.
“I’ve never seen one of these periods without a financial accident--and I mean never,” said Stephen Roach, economist at Morgan Stanley in New York. “Just because it hasn’t happened doesn’t mean it won’t.”
Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to: www.latimes.com/petruno
