Stellar stocks fall back to earth

published 30 May 2013

Equities "hit a huge air pocket" last week, says Randall F Forsyth in Barron's. Blame Japan, where the Nikkei 225 slumped by 7.3% by the close last Thursday, having been 9.2% down at one point. That marked its worst day since the tsunami of 2011 and a bigger slide than at any time during the financial crisis in 2008.

By early this week, the index had slipped by more than 10% from last week's high. That's the official definition of a market correction. Japan's jitters engulfed other major indices, wiping over 2% off European and US stocks on Thursday. There were further slight declines on Friday.

What caused the sell-off?

It's always hard to pinpoint a specific cause of a market movement, given the complex swirl of data and emotions affecting investors' decisions. But one widely cited cause for concern was a weak manufacturing survey from China, suggesting that activity in the sector shrank for the first time since last autumn, adding to fears that the world's second-largest economy is running out of steam.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

https://cdn.mos.cms.futurecdn.net/flexiimages/mw70aro6gl1676370748.jpg

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Then there were mixed messages from the US Federal Reserve. First, chairman Ben Bernanke indicated to lawmakers that prematurely ending quantitative easing (QE), or money printing, could harm the recovery. But later in the day the minutes of the latest Fed meeting showed that some Fed members would be willing to start easing up on monthly money injections in June.

Note that we're not actually talking about stopping QE, says Economist.com's Buttonwood blog, or even reversing the purchases of assetswith printed money. It would just be a case of slowing the rate of purchases. "It shows how dependent the equity bulls are on QE that sentiment could be so badly hit by such an adjustment."

Sentiment was also affected by volatility in the Japanese government-bond market. There have been unusually large swings in yields of late, including a sharp rise last Thursday. These have made some investors worry that higher interest rates on Japan's huge debt load, and the consequent cost to the economy, could deter the Bank of Japan from following through on its unlimited bond-buying programme.

However, as it controls the printing presses, the Bank of Japan should be able to buy as many bonds as it needs to prevent yields rising too fast. And there was little sign of timidity last week, says Jim Jubak on Money.msn.com. The Bank promptly calmed the markets by buying more bonds.

The best explanation is that a correction wasinevitable and overdue after the Nikkei had gained 55%, almost without interruption, in six months. Even after Thursday's fall, it was still 7% above its 50-day moving average, says John Authers in the Financial Times. "When markets get so far ahead of themselves, it is no surprise that the first negative action can turn into a big sell-off."

Is there worse to come?

Could the correction turn into a major market slide? Investors have had a reminder that markets buoyed by liquidity, rather than impressive economic data and earnings, are prone to nasty setbacks, as we pointed out last week. Nonetheless, "a real crash is hard to imagine when central banks are in effect underwriting markets", says James Mackintosh in the FT.

But this can't go on forever. Last week's global wobble suggests that there could well be a nasty slide when central banks finally stop flooding markets with money, as investors have got so used to it. The lesson of the last 30 years, says Buttonwood, is that "once you go down the path of using monetary policy to support asset prices, it's very hard to escape from it it is like paying off a blackmailer; the markets always want more."