Global Agenda: Broken markets

As the financial crisis worsens, the dysfunctionality of markets will intensify. Many markets will shrivel or be closed down by regulation.

By PINCHAS LANDAU
Stock trader monitors market movement 311 (R) (photo credit: REUTERS/Cheryl Ravelo)
Stock trader monitors market movement 311 (R)
(photo credit: REUTERS/Cheryl Ravelo)
On Tuesday of this week, the Hang Seng Index of the Hong Kong Stock Exchange plunged by some 4.5 percent. That was after China announced that its economy had grown at an annualized pace of only 9.1% in the second quarter of this year – the slowest pace in any quarter since 2009, and compared to a consensus expectation of 9.3%. Obviously, growth in excess of 9% is objectively very good, but in the markets expectations are everything, and an outcome that “disappoints” by falling beneath expectations is enough to cause a tumble. That may or may not be logical and rational, but that’s how markets work.
However, there is still the matter of degree – what is nowadays termed “proportionality.” Is a small miss in GDP a valid reason for a major market to fall almost 5% in a single day’s trading? Obviously, there is no guidebook for what is the acceptable degree of response to a specific outcome which exceeds, or falls short of, expectations. But that’s just the point: 5% in a day seems like a lot, because until recently, it was almost unheard of.
Let’s make this point in a different way. Last week, one review of the daily action on the New York Stock Exchange noted that the previous day’s trading had been the first in over 20 days in which the Dow Jones industrial Average had not moved up or down by at least one percent. In other words, moves of more than one percent in a day – which the statistics show to be relatively uncommon – are now commonplace and, indeed, have become the norm.
Other examples can be cited form around the world – and I’m relating only to major stock exchanges – which confirm the phenomenon, namely that large moves are much more frequent than they used to be.
The correct professional way to describe this phenomenon is to say that volatility has increased considerably.
Like other key market phenomena, volatility is closely monitored nowadays so that we know exactly how it stacks up compared to last week, last month, the average volatility in October, every year since 2000 – and so on. The bottom line is clear-cut: Volatility is not merely “much higher,” it is massively greater than its historical pattern.
Nor is this phenomenon limited to stock markets, although these are more prominent and more easily measured.
It is apparent across all the financial markets – bonds, currencies, precious metals, commodities and the various kinds of derivatives. The inevitable question, therefore, is “what is the cause of this phenomenon?” The standard answer is “uncertainty,” in the neutral professional jargon, or “fear” in the traders’ and journalists’ more colorful terminology. The best-known measure of volatility, the “VIX” index, is regularly referred to as “the fear index” in the media, just to get the message across. This standard answer is undoubtedly correct, but it requires elaboration – and even then, it is not the whole answer.
Uncertainty/ fear causes greater volatility, because when they are more intense, traders and investors react more strongly to new information, or even rumors and hints.
The extraordinary behavior of the markets in recent weeks, especially in Europe, but also elsewhere, to the endless flow of reports, statements, denials, trial balloons and unsourced rumors regarding plans and proposals to address the European sovereign debt crisis, is now a daily – and even hourly – live experiment on the impact of extreme uncertainty and growing fear on investor behavior, and hence on market prices.
The fear is entirely justified, because at stake is the fate of the European banking system, the euro itself, and the economic prospects of every company and every country in Europe. The uncertainty is a given, because no-one – even the heads of European governments – knows what will be agreed, let alone whether what is agreed will be implemented and, above all, whether it will succeed.
In this environment, each piece of news, whether substantiated or not, has an exaggerated impact. Everyone in the markets rushes to respond by buying or selling, and the resultant series of mini-stampedes translates into very high volatility. But this is not the full picture. The uncertainty and the fear cause many players to exit the markets entirely. The huge price swings cause more players to do so. The longer the enhanced volatility continues, the more players quit, and the more intense the volatility becomes, the greater the incentive to withdraw. In other words, the full picture encompasses both those people in the market and those who have exited, either voluntarily or under duress.
This process has been underway in the financial markets for some time and it is not merely continuing, but actually intensifying. That means that the markets are “crumbling,” not in the way that term is usually understood in terms of price levels, but in the more fundamental sense of the market’s functionality.
More and more financial markets are seizing up and ceasing to function properly. Liquidity is declining, volatility is rising and the basic purpose of markets – to act as gatherers and transmitters of information and analysis via the price mechanism – is becoming steadily more impaired.
As the overall financial crisis worsens, the dysfunctionality of markets will intensify. Many markets, especially the more exotic ones for derivative and other riskier assets, will shrivel completely – or be closed down by the growing wave of regulatory demands and of government intervention.
For professionals, this is very bad news because it threatens their very livelihood. For ordinary investors the threat is less severe, but they must still grasp the idea that a market crisis isn’t measured just by how far prices have fallen, but rather by whether the market is generating prices at all.