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."