"The market dropped so much after the Fed rate increase partly because there's so much new, nervous money"
One thing that has always intrigued me about financial
market commentaries is when market pundits say that a certain outcome
or event is "priced into the market". I always wonder if the
sampling techniques used to poll market participants are truly representative
and if the commentator making the statement actually has access to a market
survey or if it is just a gut feeling.
My feeling is that no one knows for sure how a market
will react to any event no matter how great the prior expectation is that
such an event will actually happen. I feel the present market is especially
vulnerable to market
events, expected or unexpected, which I will discuss further.
Let's look at the example of the March 25, 1997 increase
of .25% in the U.S. Fed
rate. The likelihood of this increase was broadly hinted at by the US
Federal Reserve chairman, Alan Greenspan over the previous several months.
He made public statements about "irrational exuberance" in the
stock markets and commented that inflation
was lurking down the road. This amounts to pretty strong indications that
he was concerned about inflation and market expectations of investors
and that an increase in the fed funds rate was probable. With all this
telegraphing by Mr. Greenspan, you would have thought that if any event
was "priced into the market" this surely should have been.
So what happened? Within days of the rate increase both
the US and Canadian stock markets fell and bond
yields started to rise. At the time of writing on April 5, 1997, both
300 index and Dow
Jones Industrial Average were down 5% and the S&P
500 down 4% from their March 25th levels. This happened with only
a small increase in the fed rate which was widely expected.
Why did the market drop so much? The answer is not known for sure, but one influence on the drop may have been the amount of nervous, new money that has found its way into the markets over the past few years.
As an indication, total mutual fund assets, excluding
money market funds, increased by 43% or 60 billion dollars between Feb
28, 1996 and February 28, 1997 alone. How much of this increase has been
from savers looking for an alternative to the low interest rates available
at the time of GIC
renewals and who have not previously been in an investment where their
capital can fluctuate? I don't know, but I do know that there is a lot
and I do know that many are not sure if they really want to be in the
market. They really just wanted an alternative to low interest rates and
the double digit returns of the equity markets over the past two years
looked very attractive.
It's too simplistic to say that many of these new investors
caused the large market drop by bailing out of their investments with
the first sign of trouble. Certainly, there were other factors, such as
the Bre-X issue spilling over into other stocks as well as normal profit
taking and fear of further rate increases. However this nervous money
creates an unpredictability to the market because of its volume and because
much of it has not had any exposure to a major market downturn let alone
a bear market. So I wonder if any event is truly "priced into the
market" without there being a good handle on how this nervous money
The next several months could see greater than average market volatility and for the serious investor, this will present good buying opportunities to be taken advantage of when downturns occur.
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