Economaton

The 500 point selloff in Dow Jones Industrials futures, with the
stock markets closed for the Martin Luther King Day holiday, put
“DOOM!” headlines on the front pages of all the major papers Tuesday
morning. But something is amiss. Sure, the markets slid Tuesday, and
they slid today - but it’s a different kind of slide. Financials and
homebuilders, whipping boys for the subprime mortgage crisis, actually
went up.

A bit of context: last week, LIBOR dropped below the fed’s key interest rate for the first time since 2003. (LIBOR is the London Interbank Offered Rate, the rate at which commercial banks lend to one another.) This signals a thaw in the commercial credit market; this is a powerful sign that the worst of
the financial writedowns are behind us. Banks were charging each other
more because nobody knew what anyone else’s exposure to credit
derivatives was.

Of course, there was that joint announcement in December by the
world’s central bankers saying that they were committed to unfreezing
the credit market, and announcing a huge line of credit to the
commercial banks. That certainly played a role in the current
normalization of LIBOR, but LIBOR futures didn’t start rising (meaning
a falling interest rate) until December 28th, well after the
announcement, and the yield didn’t fall below the Fed’s target rate
until last week, a month later.

What is different now is that the large banks have all posted huge
writedowns of bad credit default swaps and CDOs, for the second
quarter running. They’ve written off a worst-case scenario, far worse
than anything that is likely to actually happen. Yet another quarter
of tens-of-billion dollar losses seems very unlikely. The LIBOR rise
signals that they trust, at least among themselves, that the worst is
over.

So what happened on Martin Luther King Day? I believe (completely
speculatively; I freely admit that I haven’t a shred of actual
evidence) that a hedge fund or group of hedge funds conspired to sell
down the equity index futures, made much easier with the thin holiday
trading. They know that a 500 point single day loss in the Dow futures
has a pretty good chance of touching off sympathy selling in Asia and
Europe that night, and so it was. The news made all the papers the
next day: “Markets to crash today! 500 point loss! Europe down! Asia
down! Panic on Wall Street! AIEEE!”. The retail trader 401(k) crowd,
already jittery from months of headlines about recessions and subprime
derivatives instruments that they don’t fully understand, decided to
head for the exits, and began selling off their holdings when they got
to work. Then, the hedge funds and banks stepped in to snap up their
stocks at firesale prices.

Tech stocks and pharmaceutical companies tanked anyway - techs will be hit
hard by any recession, and the pharmaceutical companies have nothing
compelling in the pipeline. But financials, particularly investment
banks, and homebuilders rallied such as has not been seen in recent
memory. People with lots of money are buying them up in large
quantities.

These signs align to point to the light at the end of the
tunnel. Warren Buffet says his success comes from being fearful when
others are greedy, and greedy when others are fearful. Perhaps now is
the time to cautiously hunt for value in the ruins - just as the
public at large panics.