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As stock market operators, a strong stomach and preparedness for the unknown are critical traits.  Yesterday’s action in the U.S. equity markets tested even the most savvy of investors.  But, as Robert Frost famously said, “In three words I can sum up everything I’ve learned about life: it goes on.”  Indeed it does.

While the intraday move is quickly being dismissed by the CNBC punditry as a “fat finger”, or human error, and to some extent that is accurate, it is critical to remember that markets are interconnected.  The current catch phase in stock market parlance is contagion.  A contagion in medical terms is a contagious disease, and in this scenario, cotagion implies that the whole world is going to catch the Greek sovereign debt flu.

Esteemed investor George Soros had a more apt description for contagion, he calls it reflexivity.  Specifically, market events aren’t random, but they are influenced by other events.  Taken a step further, actual fundamentals are influenced by market events, so the market and prices in effect are leading indicators.

In isolation, yesterday’s event was an isolated event and was likely some Middle Aged White Guy, or MAWG has my colleague Howard Penney called him today, on a trading desk at a major financial institution who ran the wrong algorithm or sold shares when he should have been buying, albeit on a massive scale.  But the reality is that this event, which was the largest intraday drop for the Dow in stock market history, occurred on a day and in a period when the market and investors were incredibly skittish and schizophrenic due to accelerating sovereign debt concerns.  Even if this was a simple “error”, the timing was far from random.

In fact, this event is likely a catalyst for more market volatility in the coming weeks, rather than a return to complacency and the upward trend in the market.  This view is based on signals from a number of the key factors that we monitor in our risk management model, which include: credit spreads, volatility and sovereign debt credit default swaps, which are outline in the attached chart.  Collectively these factors had been signaling to us the potential for an equity market correction, and continue to signal further turbulence ahead.

Credit spreads widening in conjunction with a declining stock market typically indicate a dramatic shift away from any type of risk by institutional investors.  More specifically, they also signal bond investors getting increasingly concerned about fundamentals and cash flow.   Over the course of the past few days, corporate high yield yields widened dramatically from 8.2% to 8.6%.  This morning yields continue to climb.

The VIX is one of a few measures of volatility that we use, and it has been accurately called the fear index.  As investors get scared and sell assets, volatility spikes, which increases the potential intraday moves of asset classes.  Similar to credit spreads, equity volatility had been increasing over the past few weeks and is up another 14% this morning, signaling increasing fear and volatility ahead.

On the final point, credit default swap spreads widened for many European countries over night.  In fact, many are approaching all time highs, specifically Greece's five-year CDS rose 10 basis points to 950 basis points, while those of Portugal rose 60 basis points to 495 basis points, and Spanish CDS rose 17 basis points to 290 basis points.  If this market action is telling us anything, it is that any proposed bailout that is on the table is insufficient and there are more European sovereign debt issues ahead of us.

While we support the adage that the time to buy is when there is blood in the street, that strategy needs to be framed with the understanding that equity markets can stay irrational, and usually do, for longer than investors expect.  In early 2009, very few investors predicted that the market would climb over 75% in the ensuing 15-months.  Conversely, the correction, when it occurs, will likely be of longer duration than the consensus group-thinkers believe as well.  And perhaps the correction is only the beginning.

Daryl G. Jones

Managing Director

Correction or Contagion, What’s Next for Equity Markets? - 1