When the Beast Slips Its Leash

It looks like we just lived through the mini-Crash of 2011, a correction more or less in line with the -18% (NDQ) swoon that defined the middle months of 2010, but fast forwarded into a much shorter time frame. My assessment in the previous Musings that an underwhelming Debt Ceiling deal would allow the Market to move on seems to be coming to pass, albeit from a much lower level than I expected. That six or so days of stark raving panic I did not see coming. This was probably because I did not consider that that cyborg we call automated trading can slip its leash, especially when compound imponderables crop up during what is supposed to be a slow time of year. The action on August 8 & 9 alone are all the proof anyone should need that automated trading remains untamed beast. This Musings will attempt to offer up a post mortem on what we just lived through.

The Market did not melt down because a rating agency that has not exactly covered itself with glory in recent years officially lowered its opinion of the debt servicing ability of U.S. Nor was it because the Debt Ceiling agreement didn’t accomplish much. Both of these outcomes were all but taken for granted weeks ago. Three factors, in my estimation, account for what just scared the bejeebers out of everyone. The first two emanated from the political process. The sell-off commenced not when the Debt deal was struck but on July 22, when the “grand bargain” talks collapsed. With that event and in the days of high drama that followed, we were reminded of just how divided the primary factions within our government really are. It is a division that runs deeper than ideology. These parties have totally differing understandings of human nature, and of what is the proper relationship between the governed and those who govern should be. Our fiscal situation is not sustainable and must eventually be resolved. We don’t have to get there overnight, but we have to start moving, and to see just how fundamentally divided the two sides are made it much harder to be optimistic about the future.

It is good mental hygiene to resist that nostalgic impulse that compares the trials and oppressions of the present with burnished, if not faded, recollections of the past. Things changes, some for the better, some for worse. In the midst of that gruesome drama, as we watched our so-called leaders plumb what felt like new depths of dysfunction and wished for someone who could lead us out of this fix, an interesting article about the 1986 Budget deal appeared in the WSJ. Perhaps the most striking thing about it was a picture of two of that deal’s principal collaborators, Dan Rostenkowski and Bob Packwood. (Younger readers should go to Google to learn the ignominy which would follow these two at the tail end of their careers.) It was with no small irony that on seeing these faces from the past and reading about how they shepherded a very rancorous process to a conclusion the would ultimately undergird the prosperity that was the 1990s, I found myself wishing that today’s “statesmen” could be more like those two. That’s how far we have seemingly fallen in a moderate fraction of a lifetime. (It should also be remembered, as we go about trying to make sense of the Market’s reaction to political developments, that the liberating agenda set by the 1986 Budget Act was followed a few months later by the Crash of 1987.)

The queasiness induced by daily reminders of just how far apart the dominant factions are was exacerbated by another grim reality we found ourselves forced to notice. I find it pointless to spend too much time thinking about what the federal budget or the growth in GDP are likely to be in the future. The debt ceiling discussion forced this back to our attention, and what we saw was disturbing. Projections of continuing growth in government spending was no surprise, but what struck me were the assumptions about GDP growth. The deficit really can only be tamed if we grow the economy faster than the budget. It seemed doable, for me anyway, until I read that they have been assuming that the US economy can grow at 5% on a sustained basis, and propose to budget accordingly. To realize that the people who have to fix this mess we are in are so unrealistic is beyond disheartening.

The problem is not just that GDP is a big, nebulous, hard to measure construct. It consists of Consumption, Government, Investment and Net Exports (more properly for the US, “minus net Imports”). Its growth needs to be inflation adjusted (by applying a whole other mare’s nest of estimates), and we can only wonder what globalization has done to the math (i.e., If Apple builds a Mac in China and then sells it here, does that count against GDP?) So where is this growth that will eventually make deficits manageable again supposed to come from? We will get a little help from population growth, but that is on the order of 1%. Are we going to consume more (eat more, buy more clothes, watch more movies)? Maybe a little, but that is not much to count on. And might not Consumption be diminished, at least at the margin, to the degree that cutbacks in government programs result in fewer government employees and moderated transfer payments? Invest more in plant and equipment? Only if it is to make stuff the fast growing parts of the world want and haven’t figured out how to make yet. The real rub, the one that sticks in everybody’s craw when they ponder the details of that long road to fiscal sustainability, is how (C+I+G+nE) can grow if heretofore out-of-control growth in G has to be slowed down and probably reversed. I believe that confronted with this data every time the turned on the news, many investors were disheartened not only by just how daunting the task of bringing the deficit under control will be (that was hard to ignore from the get-go) but also by the realization that policy makers are operating under patently unrealistic assumptions like 5% GDP growth.

These factors weighed on the Market all through the late days of the debt deal, what crushed it was an outworking of Man versus Machine. Given the stellar earnings results that were being posted, in what turned out to be a sub par GDP quarter no less, it was quite plausible to expect the Market to trade up once deal was signed. Down eight or so days in a row, the Market seemed primed for a bounce, and when it didn’t, a rush for the exits ensued. When this started, we got reminded, in spades, that the advances in computer automation that have made it so easy to buy or sell securities still constitute something of an untamed beast. This automation has been a good thing, on balance, but it continues to have its moments. The role of “portfolio insurance” in turning October 1987 into an unforgettable episode comes to mind. We seem to have gotten better at keeping this beast under control, on most days under most conditions. Last year’s Flash Crash was an exception. So was this mini-Crash we just rode through. When the buttons got pushed or the algorithms simply started to respond as programmed, there was enough paralyzing uncertainty on the putative “other side of the trade” for things to spin out of control. Throw together the dissonance evoked by the GDP revisions (dissonant with respect to how well the economy seemed to be performing in light of the earnings of 85%+ of the major companies that make it up) with an unprecedented (“So what does it really mean?”) event like the S&P downgrade, and if there is supposed to any human input to that “other side”, it will hesitate. Such hesitation begets price action that begets ominous price declines and so the need for even more assessment. It was a good old fashioned panic kicked into warp drive by automatons that would have been right at home along side the Terminator. It seems to have run its course. The Market is moving on.