Excerpted from The Fearful Rise of Markets by John Authers. Published with permission of FT Press, an imprint of Pearson.
J.K. Galbraith, 1954
World markets are synchronized, and far more prone to bubbles and meltdowns than they used to be. Why? It was in March 2007 that I realized that the world's markets had each other in a tight and deadly embrace. A week earlier, global stock markets had suffered the "Shanghai Surprise," when a 9% fall on the Shanghai stock exchange led to a day of turmoil across the world. By that afternoon on Wall Street, the Dow Jones Industrial Average suddenly dropped by 2% in a matter of seconds. A long era of unnatural calm for markets was over. Watching from the Financial Times' New York newsroom, I was trying to make sense of it. Stocks were rising again after the shock, but people were jittery. Currency markets were in upheaval. I anxiously checked the Bloomberg terminal. One screen showed minute-by-minute action that day in the S&P 500, the main index of the U.S. stock market. Then I called up a minute-by-minute chart of the exchange rate of the Japanese yen against the U.S. dollar. At first I thought I had mistyped. The chart was identical to the S&P. If it were not so sinister, it might have been funny. As the day wore on and turned into the next, we in the newsroom watched the two charts snaking identical courses across the screen. Every time the S&P rose, the dollar rose against the yen and vice versa. What on earth was going on? Correlations like this were unnatural. In the years leading up to the Shanghai Surprise, the yen and the S&P had moved completely independently. They are two of the most liquid markets on earth, traded historically by completely different people, and there are many unconnected reasons why people would exchange in and out of the yen (for trade or tourism), or buy or sell a U.S. stock (thanks to the latest news from companies in Corporate America). But since the Shanghai Surprise, statisticians show that any move in the S&P is sufficient to explain 40% of moves in the yen, and vice versa. As they should have nothing in common, this implies that neither market is being priced efficiently. Instead, these entangled markets are driven by the same investors, using the same flood of speculative money.