2005 is off to a rocky start


This market scares me.

There are always strange internal inconsistencies in markets — efficient markets are a myth — but not usually like this.

6 straight days of down days on the Dow, and the financial news is pinning this on dollar strength and inflation fears. That reasoning does not hold water.

If inflation is the underlying issue, then why are commodity prices falling? Specifically, why aren’t we seeing the flight to quality that normally lifts the price of gold. And if this is a strong dollar story, then why are foreign stock markets falling essentially in line with US markets? And why is the VIX (Volatility index) down? Normally, with trending stocks, the VIX moves up. When the VIX moves down, options prices generally fall.

It’s a strange combination: Stocks down, bonds flat, options down, commodities down, foreign stocks down.

Pure conjecture:

Maybe some big funds had to do some major asset allocation. For example, if i maintain both stocks and bonds at specific percentages of my portfolio, and my stocks went up more than my bonds in 2004, then rebalancing would mean selling some stocks to buy bonds just to keep my asset allocation constant. If the asset allocation included global stocks, bonds, and commodities, then clumsy execution of that kind of trading could lead to the kinds of moves we saw today.

Another possibility might be that large scale selling of global stock markets, commodities, and options (to a smaller degree) by smaller investors is moving capital into US dollar-based cash.

Implications:

Prices are lower and the risks do not seem to have fundamentally changed. However, this feels like a red flag for possible crash in order of 8 to 15%. I’d put those odds at 5% for the next month. If markets right themselves – or at least reestablish their normal linkages – then I’ll feel much more comfortable again, and would overweight international equity beta with a weak dollar emphasis.

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