360 Degrees of the Market

Top 10 Myths of Tuesday's Correction

By Barry Ritholtz

This was originally published on RealMoney on March 2 at 3:38 p.m. ET.

On Tuesday, a long overdue market correction took place. At its worst, the Dow Jones Industrial Average was down well over 500 points. As has been recounted endlessly by the media, this was the worst single day since Sept. 17, 2001.

It didn't take very long for the spinmeisters to get busy. Numerous reasons were spun out as to why stocks fell -- ranging from merely uninformed to misleading to utterly false. I have seen, read or heard each of the following reasons offered either on the major networks, in the business press, or on the radio. While you have likely seen most of these, I doubt you have seen the facts figures and analyses that follow each.

My top 10 myths of the Great Correction of 2007:

1. Chinese regulators caused the meltdown.

The timing of the Chinese news release makes this statement suspect: On Sunday, China's main stock exchanges (in Shanghai and Shenzhen) issued new guidelines regulating member securities companies.

An article on the subject "China tightens regulation of securities dealers with new rules" was posted at www.GOV.cn on Monday. Here is an excerpt:

China's Shanghai and Shenzhen stock exchanges issued on Sunday the new rules of regulating their member securities companies in a bid to ward off risks in stock trading. The rules, which will come into effect on May 1, set limits to the varieties, methods and scales of stock trading that dealers are allowed to conduct, preventing them from engaging in high-risk business beyond their capacity.

Note that these details were released on Sunday, and on Monday Chinese markets set new all-time record highs! Indeed, despite recent official discussions of new capital gains taxes, increased regulation and the government's desire to reduce speculation in China, their indices had advanced 13% in the prior six sessions -- all setting records.

2. It was Greenspan's fault.

I've given Easy Al a lot of grief over the years. His answer to most any problem is "more liquidity."

However, he doesn't deserve the blame for this one. Given the specifics of what the former Fed Chair said, as well as the timing of his commentary, it is doubtful he had much impact.

First off, Greenspan didn't say anything that was off consensus. His damaging quote?

"While, yes, it is possible we can get a recession in the latter months of 2007, most forecasters are not making that judgment and indeed are projecting forward into 2008 ... with some slowdown."

Those ain't exactly fightin' words.

Then there's the timing issue. His comments were made early Monday morning over satellite to a group of Hong Kong investors. It was subsequently reported by Bloomberg and others. By 6:49 am on Monday morning, I had already blogged it, noting tongue in cheek that "Greenspan Forecasts Recession (Market Expected to Rally)."

As noted above, Chinese markets rallied, and the US markets were flat on Monday. So to blame what happened Tuesday on Greenspan's comments hardly makes sense.

3. Blame China's market crash.

On Tuesday, China's main indices were off 8.8%. However, it is doubtful this is what led to the cascading selloff in the US.

Why? Most local markets in Asia were off only modestly. The Hang Seng (-1.76%), the Kospi (-1.05%) and the Nikkei (0.52%) all had minor losses. (Note that some Asian markets close earlier than China's.)

Second, consider this fact: The combined value of China's Shanghai and Shenzhen stock markets -- the total market capitalization -- was $400 billion at the end of 2005. Over the next 14 months, it nearly tripled. Gains over the past six months were especially strong. After Tuesday's 8.8% plunge, the combined market cap was a mere $1.4 trillion, vs. $400 billion at the end of 2005.

To put that into some context, the NYSE's cap is $22.3 trillion, and the Nasdaq's cap is $4.2 trillion. Add in the Amex and other markets and the total US market cap is north of $27 trillion dollars.

By my back-of-the-envelope calculations, our 3.5% correction wiped out nearly a trillion dollars in US market capitalization, or more than two-thirds of the entire capitalization of both of China's exchanges combined.

I doubt Communist China's relatively small public markets alone are responsible for what happened here.

4. A Dow Jones Glitch caused the plunge

An absurdly false statement. By 2:55 p.m. EST, the Dow was off 295 points, the Nasdaq was down 95 and the S&P 500 was off over 3%. Indeed, trades in the Dow Diamonds and all 30 individual Dow Components were being reported correctly. Only the index (".INDU" on ILX or Bloomberg) was lagging.

Once the glitch kicked in around 3:00 p.m., most of the damage had already been done. Indeed, until that time, the glitch actually made trading look more orderly then it was. When Dow Jones switched to its back-up server, it rammed nearly an hour's worth of lagging reports through in just a few moments, moving the selloff from mild to wild in 60 seconds.

5. We got fluctuated!

On "Kudlow & Company" Tuesday evening, and then again in a Wall Street Journal editorial on Thursday, my pal Larry Kudlow went to the infamous J.P. Morgan quote, saying "Prices fluctuate."

Maybe, but prior to Tuesday, volatility had been nearly abolished and markets had only moved one direction -- higher. I mentioned this market was challenging J.P. Morgan's notions with its lack of volatility. When Kudlow corrected me -- "Morgan said Fluctuate, not Volatility" -- I replied "We got fluctuated pretty good on Tuesday."

And as I am writing this on Friday, we seem to be getting fluctuated pretty good again today.

6. Stock prices will be higher six months from now.

This one is only half wrong: Based on prior one-day selloffs of 3% and 4%, what is most likely is that we will see higher and lower prices over the next six months to a year. So unless you plan on buying stock and then hiding on a desert island, prepare yourself for some big price moves.

Consider 1997: From Oct. 16 to Oct. 24, the market suffered three days where prices were down between 2.5% to 3%. The next trading day (Oct. 27), the Nasdaq dropped about 100 points (-6.2%). The day after saw a gap down of another 75 points, but then the market rallied, closing up over 9%! Some more upward progress was followed by an 11% setback. The washed-out markets set up a 30% rally by April 1998.

A similar pattern occurred in 1998. April 6 and 7 saw 1.7% and 2% drops, respectively, followed by oversold conditions, leading to a 10-day rally of about 7%. That set up some wild market swings over the next six months: a 10.7% selloff, an 18.2% rally, a 27.2% selloff. From there, we saw a near 20% snapback, leading to a 23.6% correction, and by Oct. 8, 1998, the markets had erased the gains for the entire year and then some. The deeply oversold conditions led to a rally that was up about 60% by the end of 1998, and tagged an 86.7% gain on by Feb. 1, 1999.

December 1999 and January 2000 saw several 3% down days. The market peaked on March 10, and two days later suffered a 6% (peak-to-trough intraday) whack. The next day was another hit of near 4%. These moves set 2000 up for what would turn out to be one of the wildest years in market history. From that March peak to the beginning of April, the Nasdaq dropped 29%. A 22% bounce by April 10 was followed by a 27% drop, a 23% gain and a 23% selloff. And that was all before May was over!

From the lows in May, the Nasdaq subsequently rallied 41% by mid-July. Between then and Sept. 1, the Nazz dropped 17.9% and rallied 21.0%. From September to December, the Nasdaq markets then dropped over 40%, to just about 2,300.

Here we are nearly seven years later, and we are less than 100 points above the levels of December 2000.

7. Selloffs such as this are healthy.

Moderate selloffs of 0.5% to 1% might be healthy, but the plunge this week was anything but.

What was unusual about the selloff this week were the volume and market internals. Volume on the NYSE and Nasdaq were record setting. The Nasdaq-100 Trust(QQQQ Quote) traded well over 300 million shares alone. Advance/decline ratios and up/down volumes were off the chart.

This looked like the kind of panic selling we see at the end of a long decline. Indeed, if we had been selling off for the prior six months, I would have been advising everyone and their mother to be in there buying hand-over-fist.

What makes this situation potentially dangerous is that this was the first day of the selloff, not the last.

The enormous distributive volume and the horrific market internals were anything but healthy. It suggests a major change in underlying metrics and psychology.

8. The Fed stands by ready to cut if this gets much worse.

It's become the rallying cry of the bulls: The Fed is cutting! The Fed is cutting!

The problem is that card has already been played and we know how that turned out. The Fed did this during the last recession/market crash (2001-03), and the resulting rampant inflation, unaffordable housing boom, $75 Oil and $750 Gold is what they have to show for it.

Inflation, though moderating, still remains elevated. I suspect the Fed will be somewhat reluctant to open the spigots again anytime soon. Ben Bernanke knows all too well that there is no free lunch. He is well aware that inflation is above all a monetary phenomena.

Hopes for rate cuts are misplaced. If we are to believe the Fed's jawboning, it is inflation, and not stock prices, that has the Fed most worried. That concern is warranted, going by the recent Core CPI and PCE data. Oil, medical care and food prices all remain quite lofty.

9. The market is not forecasting a weakening economy.

For the past six months, I have heard repeatedly that the markets are forecasting economic growth, and that the rally was proof that the economy was not slowing.

Apparently this is part of the "ratchet wrench approach to analysis." It only works in one direction -- e.g., oil is disinflationary coming down, but somehow not inflationary going up, or lower gold prices are proof of low inflation, while higher prices are proof of speculation.

The lack of symmetry is revealing of bias. If you believe that markets discount the future, then it's all but impossible to say that a 500-point intraday drop has no economic significance.

10. This had nothing to do with anything fundamental!

A long string of punk economic data was finally broken by a marginal ISM report Thursday. But that was cold comfort to those who track the economy and have noted the ongoing deceleration in growth.

Probably the most overlooked story from Tuesday was the live interview with Freddie Mac's chief on CNBC early Tuesday morning. Freddie Mac essentially announced that they would "stop purchasing subprime loans or any securities with high risks of default."

In 2006, about 15% of new mortgage originations (not refis) were sub prime. Add in the various "liar loans" where there is no income check and no documentation is required, and other flavors of exotic fare such as interest-only loans, and piggyback mortgages that allow 100% loan to value, and you have as many as 30% of new mortgages.

With one fell swoop, Freddie just eliminated between 15% and 25% of home purchasers from the credit pool, and that just set the housing bottom-callers back another year.

Drawing Fact From Fiction

Since the summer, the rampaging bulls have had their way with just about every market on earth. Volatility had been subdued and risks ignored.

That era is likely over now. Indeed, the general commentary ("buy the dip, hold for the long term") may be ignoring a developing shift in psychology. It reeks of complacency.

In a note to clients after the plunge, we said to expect three things:
1) Increased volatility;
2) attempt(s) to return to prior market highs;
3) deeply oversold conditions that will eventually create great entry points.

Traders are likely better off waiting for these conditions prior to jumping into long-side trades.