the situation

On Wednesday, and to a greater degree on Thursday, world stock markets declined sharply, across the board, in a selloff that has more than a whiff of panic about it. 

The trigger for the downward move is worry about EU banks.  As the Greek crisis drags on without resolution, interbank liquidity in the EU has been gradually drying up.  Everyone figures that banks will eventually have to write down part the value of the Greek government bonds they hold.  No financial institution wants to be caught, when the writedowns occur, having lent even short-term money to any bank whose credit rating becomes impaired in the process.

On this side of the Atlantic, Washington’s fear-mongering about the possibility of government default has caused companies to stop hiring, and consumers to stop spending for the moment.  It has also created enough anxiety that money market funds here, worried about possible redemptions, have withdrawn their financing from EU banks in recent weeks as well.  That has made an awkward EU situation worse.

All this has conjured up fears in Europe of a mini-Lehman event there.  As every investor recalls very vividly, the Lehman bankruptcy in September 2008 brought global trade finance to a screeching halt, paralyzing economic activity for a number of months and producing massive corporate layoffs in response. 

Hence the selloff.

is this rational?  is this likely?

My answer is “no” to both.  Is it thinkable?  Yes.  And that’s enough for a market that’s feeding on negative emotion to use as a rationale for decline.  It also doesn’t help either that this is August, when most senior European portfolio managers are on vacation–and, strangely, to my mind, apparently incommunicado.

there are problems

The US and EU are facing a serious economic problem.  Growth is barely above zero and will likely not be much better in the near future (in other words, things will eventually improve, but I have no idea when).  That’s mostly necessary healing in the wake of the housing/financial crisis.  But a coterie of politicians bred to run for office but with no clue about what to do once elected is not helping, either.

It’s also worrying that governments in developed countries have already used up most of the growth-inducing weapons in their arsenals, leaving them vulnerable to new external shocks.On the other hand, this is not new news.

what to do

To my mind, there is a strong positive case for stocks.  It doesn’t depend on accelerating economic growth, although it does assume we don’t go into a serious tailspin.

My argument is that:

–emerging market will remain strong, and

–we can separate overall lackluster growth into two parts:  say, 85% of the workforce that is doing increasingly well, and 15% (up from 5% in a “full employment” economy, that isn’t.

Since publicly traded equities, especially in the US, are overwhelmingly focused on more affluent consumers and on emerging markets, we should be able to find strong money-making stocks, even if economic growth is lackluster and the overall market drifts.

I think the negative emotion expressed in the current selling is so large that it won’t disappear in a day.  So I think it’s better to wait to see the market stabilize than to “catch a falling knife,” as they say in the UK, and add to equity exposure on the way down.

At the same time, since the selling seems to me to have been indiscriminate, don’t be afraid to upgrade your portfolio by getting rid of stocks that have mostly exposure to broad economic activity in the domestic market, and replacing them with stocks that have emerging markets profit exposure and an up-market consumer (not industrial) clientele at home.

More on this in the next few days.