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Volatile Trading Underscores Bull Market's Fragility

Monday, 21 Mar 2011 10:00 AM

 

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When it comes to the mood of the market, strategist Brian Gendreau called what happened on Wednesday Exhibit A.

Stocks were already falling when the European Union's energy chief warned of an impending nuclear catastrophe in Japan. It didn't matter that few investors in the U.S. had ever heard of Guenther Oettinger or that other reports from Japan weren't quite as dire. The Dow Jones Industrial Average fell 200 points in the next four hours.

"The market went up so far so fast, and investor surveys were showing a great deal of bullishness, the kind we often associate with the peak of a bull market," says Gendreau, of the Financial Network, a financial advisory firm. "Whenever you're fully invested in stocks — when everyone's on one side of the trade you're very vulnerable to bad news.

"We got some bad news."

The Dow Jones Industrial Average moved by more than 100 points four straight days last week. At one point it gave up all of its gains for the year, as investors digested world events ranging from an earthquake and possible nuclear meltdown in Japan and turmoil in Libya to more signs that the U.S. economy is improving.

But by week's end, the Dow was again up for the year by more than 2 percent.

The message for investors: Get used to volatility like this.

U.S. companies, for the most part, are in good financial shape. Earnings are expected to be strong for the first quarter, and they've never had more cash. But world events — like a nuclear disaster in Japan or a protest in Saudi Arabia — can quickly jolt investors.

The S&P 500 index is down roughly 5 percent since they reached their recent highs in February, according to Standard & Poor's. That's enough of a drop to qualify for what market technicians call a pullback. There have been 53 such losses of between 5 and 10 percent since World War II, according to Standard & Poor's. Most pullbacks have averaged price drops around 7 percent, and required an average of two months to get back to even.

By that measure, the market could recover its losses before summer — unless something else happens to spook investors.

Higher gas prices, concerns about the impact of earthquake and tsunami on the world's third largest economy and the possibility of a government shutdown in the U.S. over a budget fight are things that would qualify.

"There's a lot of uncertainty, and markets hate uncertainty," Gendreau says.

Moody's Investors Service warned on Friday that if oil prices remain around $100 a barrel, it will imperil the global economic recovery. Carmakers, airlines and agricultural companies would be hit the hardest. Oil prices may soon surge if Japan weans itself off nuclear power. Economists think that oil prices above $130 could push the U.S. into another recession.

Looming over all of this is the Federal Reserve, whose $600 billon effort to stimulate the economy and buoy stock markets expires at the end of June. The Fed's stimulus program has helped the S&P 500 gain 19 percent since Fed Chairman Ben Bernanke first hinted at the plan in August. Investors were willing to shrug off bad news about the economy because of their faith in the Fed's powers. Now, they get to see if the economy and stock markets can stand on their own.

"We aren't going to think about new highs for the year until after we get past the end of (the Fed's bond-buying program), at least, and maybe not until the end of the summer when we see the effect of higher gas prices on corporate earnings," says Paul Zemsky, head of asset allocation at ING Investment Management.

Stocks aren't bound to fall into another bear market, says John Brady, senior vice president at the brokerage MF Global. Companies are largely healthy, he argues. That's what should matter most to investors.

There are a few bright spots in the market. The Russell 2000 index of smaller companies has lost 1 percent since the earthquake in Japan, a slide that is less than half of the pullbacks of large company indexes like the Dow or S&P 500. That's a surprise, considering that the smaller, riskier companies tend to fall the most during stock downturns. Last year, for instance, the Russell index lost 2 percentage points more than the S&P 500 during a market drop that lasted from April to June.

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