U.S. Markets closed

Reality Check for Wall Street: Psychology of the Sell-Off

Michael Santoli
Michael Santoli
The Exchange

Like anything complicated, a dramatic market move is inevitably driven by things we know, things we don't, and things we know that just aren't so. The past two days' 3.5% stock sell-off has had an unusual volume of sloganeered causes pinned to it, making it all the more important to figure out where the obvious factors deviate from the valid ones.

Here's a run-through of some of the political, economic and technical elements said to be at work in this swift market gut-check:

The election
President Obama's re-election was a close enough call as of Tuesday morning that a significant number of investors clearly set up a tactical bet on a Romney win.

Even though the overall market had closely tracked the betting markets' probability of an Obama advantage most of the year, in the days ahead of the vote large bank, defense names and coal stocks — the go-to beneficiaries of a notional Romney administration — jumped sharply.

These trades have been largely unwound, judging by the steep underperformance of the targeted sectors since Tuesday, so this should not be an ongoing drag on the market.
The idea that a broader flight from stocks was prompted by the re-election is far more popular than it is plausible. Obama was statistically leading or tied in polls for months ahead of the voting, so his win wasn't news to the bloodless collective judgment of the equity market, whose uptrend the past few years co-existed with Obama's presence in the White House.

Yes, the investor class on balance was disappointed and fears some policy implications of a second Obama term. But any reflex selling based on the Electoral College outcome alone has to be considered a temporary impulse.

The fiscal cliff
This impending expiration of some $600 billion worth of annual tax cuts and spending measures, arriving Jan. 1 unless Congress acts, has gone from obscure preoccupation of economists and Washington wonks to a full-blown public obsession in about 72 hours.

Big, scary numbers, an economy still trying to summon momentum, a suspenseful deadline and hostile partisan politics combine to form an ideal cable-talk outrage-fest and a crescendo of damn-them-both civic disgust.

Let's first grant that it's potentially a rude episode for the economy, and then get to why it's being overplayed as an excuse to dump stocks two months ahead of time.

Yes, the election left in place a president and a Republican House leadership determined to hold firm in their negotiating demands. We have a president with the understandable confidence of a man who will retire at age 55 a perfect 2-0 in national elections, and disciplined Republicans with unassailable control of the "people's chamber." Offensive coordinators on both teams are probably both sketching out tactical game plans that at some point say "and then the markets will panic and the other side will buckle."

Yet this is not quite the "Will they stop in time?" rush toward certain disaster of popular imagination. It's more like the scene in "Groundhog Day," when Bill Murray learns he can drive off a cliff, emerge unhurt and then do it all over again the next day.

The $600 billion is an annual number, so the fiscal-contraction clock starts ticking Jan. 1 at a rate of $50 billion a month. But at whatever point there's a deal, the clock stops without much harm. It's also not all or nothing, a grand bargain or bust. Pieces of the sunsetting stimulus measures can be extended or nullified as here is mutual agreement.

And while the Congressional Budget Office has said the total fiscal hit would reduce GDP by 1.9% and probably tip us into recession, all else being equal, all else won't be equal.
The Federal Reserve, for one, will already be sending a fresh $40 billion a month into the banking system by then, and it's in the business of doing what it can to forestall recessions, especially widely predicted ones.

The resurfacing of concerns about the European economy and the progress of the Greek bailout and general sovereign-debt firewall there might be the one factor not getting enough credit for the market queasiness.

The sharp slowing of Germany's economy and another round of complications in securing believable backstops for struggling government issuers is boosting the dollar (a drag on stocks) and will filter through to multinational earnings.

Things there are far from reaching dire conditions again, and Spain yesterday pulled off a successful bond auction that takes care of its funding needs until next year. But watch European credit and stock markets for further evidence of stress — for if it surfaces it will have nothing to do with U.S. policy or budget concerns.

Market technical clues
Stocks were showing waning momentum well before the bleating about taxes and cliffs got loud this week. Yesterday the Standard & Poor's 500 sagged below its 200-day moving average, which many market handicappers believe means the market's prevailing trend is no longer up.

Of course, in the spring the index undercut its 200-day average in giving up all the gains from Dec. 31 to that point, but then quickly reversed higher into September.
Other measures of stock supply and demand and investor psychology have entirely undone the overconfident headiness evident around Labor Day,  but few are showing the sort of panicky, indiscriminate flight instinct that often — but not always - prevails as a downturn culminates. If this is what's necessary for some kind of bottom to be set, it would likely come with indexes a few percent lower.

Yesterday, there was a quite-unusual instance of the market falling more than 1% while the S&P 500 Volatility Index (VIX) also declined significantly. Usually the VIX — which rises with the prices paid for protective options — climbs in a fear-dominated daily tape. In the very short term (days or a couple of weeks) this can mean that the clued-in pros sense the selling is abating for a little while.

While it might sound trite and dull, the greatest concerns for stock investors should involve the advanced age of this bull market, corporate-profit cycle and the outlook for improvement in the real economy.

Some 45 months removed from the bear-market low, stocks have tracked a massive recovery in company earnings, to historically high profit margins bolstered by heroic productivity gains. Stocks can continue grinding higher or arrest their current decline as profit margins flatten out, yet only if global economic-growth begins to seem sturdy and long-lived, as companies at last pivot from milking technology to adding workers and drive a better consumption-and-hiring cycle.

The U.S. consumer, housing and even manufacturing data have firmed and GDP estimates for this quarter are being nudged higher. Less worrisome inflation in China gives authorities there clearance to gun the growth engine harder. The question is whether persuasive evidence of a sustainable pickup will arrive before financial markets lose what patience they have left with the various potential man-made accidents now consuming investors' attention.