Can You Say Death Spiral?

This morning (American time), an hour and a half before the markets opened, I sent my sister an email. The European markets had all posted modest gains, and futures on all US indicies were in positive territoy, indicating that traders in Europe thought the US market would finally break it's losing streak today. Nevertheless, in my email, I wrote, "Watch this, everyone thinks the markets are going to go up today, but they are going to end up down again." When I left to go have some dinner with my friend Tanya, the Dow Jones was in modest negative territory. Now that I've come back 3 hours later, I find that the index has plunged almost 700 points and has destroyed the 9,000 point milestone, closing around 8,600. The first time the Dow broke through 8,600 was in some time in the Winter of 1998, over 10 and a half years ago. Today's market reaction confirms something I have suspected for a few days. We are no longer in a normal correction, now we are in a death spiral.

Over the past couple weeks, there have been quite a few positive developments,from the passing of the bailout plan, to the coordinated rate cuts, to the Fed's move to start buying up commercial paper to take the strain off the money markets, which would normally, at the very least, spark a rally on one of those days. However, the Dow and the S&P have experienced significant declines for 8 straight days. After the Fed's October rate cuts, the Dow hit its high of around 14,100, even after the credit crisis had began. These haven't been small 100 point declines either. Every day, since September 30, except for one has marked over a 100 point decline. All told, the Dow has declined over 2,000 points in 8 trading days. While many in the media have been chalking the markets' recent performance up to investor fear, there is clearly something greater at work here, given how oversold the market is. Surely some intrepid investors would see this for the buying opportunity it is and stick their necks' out.

While people often times view the stock market as a reflection of the economy, it is wrong to the markets' recent performance and try to generalize it to the economy as a whole. While America will definitely experience a severe recession and maybe even a depression, current market forces are currently divorced from economic realities as in any death spiral. A death spiral occurs when the market suddenly plunges. Investors, who were investing using significant leverage are then forced to make margin calls, selling off assets to prevent their brokers from siezing their assets. These sales drive asset prices down further, resulting in a positive feed back loop with more sales resulting in more margin calls. While investor fear and uncertainty have certainly played into this death spiral and exacerbated it, they are not necessarily at the root of this. Over the past few years, as hedge funds have proliferated, the amount of leverage in the capital markets has increased dramatically, thus resulting in a greater possibility of a death spiral.

To date, hedge funds, high-risk, investment vehicles, have been perfoming poorly, despite their claim that they can return a profit in any market. The average fund was down about 10%, at the end of 3Q, before this mess started. So when, September 30, the end of the third quarter, rolled around, hedge funds were hit with a wave of redemptions from investors. To meet these redemptions, hedge funds have been forced to sell off assets, depressing the market. Note the latest streak of declines began on September 30. These assets sales have bloomed into a full blown death spiral, as hedge funds attempt to close positions, to preserve their investors positions and are hit with margin call simultaneously. No amount of positive news or investor sentiment can stop this wave. It will just continue to roll, until all the hedge funds are able to meet their investors' redemptions.