Forces at work from Tokyo to Kiev have been roiling the U.S. stock market for a couple of week. But the financial sushi that is now on the menu in Japan, and Russia's "Crimea of the Century" are only part of the story.
Japan is trying at long last to revive its moribund and literally "deflated" economy by a combination of easy money (to spur needed domestic inflation, weaken the yen and grow exports), structural reforms and a major sales tax increase to reduce the overwhelming level of government debt brought about by decades of fruitless "stimulus" overspending on unneeded infrastructure. Sounds good. But traders in the U.S. have come to fear that Japan's Fed is not pumping out easy money fast enough to offset the tax increase, which in turn will slow rather than stimulate the Japanese economy and cause the yen to rise undermining the traders so-called "carry trade" -- borrowing cheap yen to convert into dollar equities thus boosting U.S. equity prices. If everyone unwinds the "carry" at once -- as has been occurring recently -- equities fall hard, especially while the U.S. Federal Reserve is slowly but surely unwinding its own extraordinary quantitative easing program. The whole scenario also threatens the positive outlook for enhanced global economic growth that we started this year with, further undercutting equities.
The Russian invasion and annexing of Crimea has gradually added to global growth worries and equity jitters, but obviously not because of any financially strategic characteristics of Crimea. With a U.S. president facing political pressure to prove he can "stand up to Putin" from a public that nonetheless has utterly no stomach for military intervention in Ukraine, the only "weapons" available are economic sanctions of the "this will hurt me more than it hurts you" variety. The "personal" sanctions against Putin's oligarch cronies are not the equity traders' problem. But moving to the next level of sanctions on trade with Russia, ultimately including energy products like oil and gas, would impose pain for the entire European economy, which has enough troubles of its own from the Eurozone crisis hangover.
Other sources of energy imports, including from the U.S., can't possibly come through fast enough to spare Europe a recession if Russia further destabilizes the eastern Ukraine or even invades and the West is forced to go to "DefCon 4" level trade sanctions. As a result, nervous traders are watching the Ukraine/Russia border even more closely than the CIA. (Why didn't they borrow some of NSA's tricks and snoop the Vlad-phone before Putin made his move?)
In the midst of these growth-threatening circumstances, along came 60 Minutes worth of Michael Lewis' latest exposure of Wall Street excess ("The Flash Boys") undermining confidence just when confidence is what investors need most. Lewis revealed in plain English the millisecond advantage high-speed, computer-driven traders have enjoyed -- with the profit-related connivance of the major stock exchanges and the unwitting assistance of SEC market reformers -- allowing them to jump ahead of buy or sell "market" orders from you or me or the biggest institutional traders to make gazillions of risk-free penny profits by forcing us to pay more than what our computer screens tell us is the "market' piece. Simple, computer-elegant, virtually un-measurable and probably legal front-running.
While the Lewis book no doubt caused some 60 Minutes retail investors to pull their money out of stocks, professional traders haven't really been moved to dump equities by the notion that their customers are being nano-skimmed. They are more concerned by Lewis's reminder of the power of computer-driven trades set to algorithms that can trigger massive and sudden market sell orders based on momentary and even accidental extraordinary price changes in single stocks or ETF's.
The famous "Flash Crash" a couple of years ago was just such an event. The Lewis book effectively underscores the fact that we can't get really get to the bottom of the chain of events that actually caused that sudden market collapse because our trade monitoring devices can't get down to the millisecond level. The "pings" of such trades simply are undecipherable with current market-policing technology -- they are effectively lost in the vast Indian Ocean of dark- pool private exchanges that sprang up in response to the regulatory reforms designed to open up the stock exchange oligopoly to more competition and thereby lower "spreads" between bid and ask prices. It did so, but to so a fine degree of fault that traders can't really tell that their pockets are being picked. (By the way, the flash crash happened in May, so no surprise that equity traders start to get nervous memories in April.)
Finally, the "rotating correction' -- from bio-techs to cloud computing to big data and finally to anything with a high P/E multiple -- that has rolled through the equity markets in the first week of April was triggered by a couple of oddly interpreted events. First, Congressman Henry Waxman of California (a retiring but not shy Democrat) and a couple of his Party colleagues wrote a letter to Gilead asking why the company was charging $1000 per pill ($84,000 per full treatment) for the newly approved and highly effective Hepatitis C drug. Note Waxman is a Democrat and thus virtually impotent in the Tea Party dominated House of Representatives. But never mind. Traders dumped Gilead like a failed Phase III trial and took the whole biotech world down with it purportedly on fear that there was a serious threat to drug pricing going forward. Nonsense -- at least from the government. But when the largest pharmacy benefits manager, Express Scripts, took up the same cause this week, the threat at least looked a little more real. No doubt many biotechs were trading in bubble-land -- but not particularly Gilead.
Then a couple of high-flying technology and biotech companies had the gall to do a secondary offering in the midst of a great run for IPO's in the same sectors over the first quarter and into early April. Our beloved equity traders are supposedly strong free-market capitalism advocates, who urge our politicians to keep the tax breaks in place for the venture capitalists who deserve the rewards of their successful investment because they are such prolific "job creators."
But when the VC's have the nerve to cash in those chips with secondary offering of their own shares that dare dilute the sleepy traders by surprise -- somehow they didn't notice those stocks were also at bubble-land prices -- there is hell to pay for the rest of the shareholders, as those traders joined the secondary sellers in unloading their own inflated shares, taking profits and continuing to sell down if only to preserve capital for a later run.
Many market commentators broadly praised this "multiple correction" as portending an overall return to a more "normalized" trading environment without the extreme multiple expansion of the last couple of years that some prominent voices believe is more attributable to the Fed's money than the companies' revenues or even their profitability (which for some as yet is non-existent). But more than a few healthy babies have been thrown out with this bath. Warning to the commentators: Be careful what you wash for!
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By Terry Connelly, Dean Emeritus, Ageno School of Business, Golden Gate University
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.