Punchinello’s Chronicles

November 6, 2009

Why the Stock Market is Swinging so Wildly

I didn’t used to be interested in economics, they were confusing and complicated. But I grew up in a family where money and economics were part of the everyday conversation. My dad was in the Navy, and so we also spent a lot of time around boats, beaches, the ocean, and sailing. I also learned to sail when I was a kid, and as a teen, got to take the boat out on a regular basis. One of the scariest things to experience is being in a small boat caught in a storm. And part of that fear comes from the dangers of what’s called following waves.

Following waves are the ones that are behind you, moving in the same direction as you’re sailing. The waves usually are traveling faster than the boat, and if those waves get big enough, they cause all sorts of contortions in your movements. They can catch the back corner of the boat and swing it wildly to the left. Then the next wave catches the other corner and just as quickly slams the boat to the right. Back and forth, faster and faster, until a big wave slams the boat sideways to the waves. Then you capsize.

Another big danger of following waves — meaning waves that are behind you, following you as you sail — is that they can cause the boat to turn into a surfboard. If the waves are large enough, they literally pick the whole boat up and carry it forward as fast as the wave is traveling. That means you have no steering, no control, no rudder, and your engine (or sails) mean nothing anymore.

DOW volatility is a boat in a storm

The Financial Markets Pushed by Stimulus Money

Take a look at this little patrol boat trying to handle big following waves. Some might think it’s kind of fun being a surfboard in the middle of the ocean. But take another look at the front (bow) of the boat. If the wave behind it lifst the stern (back) strongly enough, the tip of the bow will go under water. At that point, the force of the wave takes the entire boat and cartwheels it head-over-heel (stern-over-bow) across the ocean, like a pinwheel!

Or, more simply, the bow goes under and the entire force of the ocean just slams it down into the bottom of the ocean.

Think of this patrol boat as the stock market and financial markets. The waves behind it are the free money coming from the Federal Reserve. Stimulus money is a massive wall of water, much like the ocean. It’s almost unlimited and means nothing other than water. There’s no actual value behind all this stimulus money, it’s simply fiat money being created by borrowing against an unlimited check book.

Now imagine how this boat is being slammed around by those waves. It pitches up and down wildly, and swings (yaws) back and forth like a car on solid ice. The boat has no traction because it’s on the water. The car has no traction because it’s on ice. Basically, the same thing excepting that the boat has a strong force behind it. The car only has its momentum and speed when it hits the ice. The Federal Reserve stimulus money is like BOTH a snowstorm, and putting the car of the markets on a steep hill.

In this particular picture, the waves are large enough that they could slam the boat into the bottom, bow first. If the engines on the boat are powerful enough, they might outrun the waves. A better solution would be a “sea anchor.” This is a long rope with a heavy bag that’s let out behind the boat. It serves to slow the boat down, allowing the waves to go under the boat and lift it up without turning it into a surfboard. The danger is that a large wave and slow boat might mean the wave swamps the boat, covering the entire thing from the back to front.

The first step is to get out of the storm. But if you’re in the middle of the ocean, that’s not an option. The next step is to throw out a sea anchor and slow the boat down. Another option is that a boat usually does way better when it faces waves head-on, as the front of the boat offers a much smaller target for the waves. However; turning the boat around in a storm means offering the side of the boat to the waves. They would just roll the boat over.

If you’re in a car traveling at 5 miles an hour when you hit ice, you start to skid. The back of the car begins to swing left and right, but at least there aren’t any waves rushing at the back of the car. Eventually, you reach a tipping point and the back of the car swings out of control. The car goes into a spin, loses control, and only stops when it hits something or gets off the ice.

Hitting a wall at 5mph is one thing. But if you were driving at 60mph when you went into the skid, hitting the wall is an entirely different problem. So too, the size of the waves behind this boat introduce pressure, force, and speed to the situation.

We’re facing a blizzard of economic problems around the world. Using the same logic as the newscasters, we should be shouting at the Federal Reserve, the SEC, the Obama Administration, Congress, and all the regulatory agencies standing on the sidelines: “Slow it down!”

We could potentially get out of this storm by refusing to allow the Federal Reserve to pour liquidity (money) into the markets. That would go exactly opposite to Keynesian economics, so it likely won’t happen. Or, we could put a drag on the markets, introducing some sort of actual and meaningful regulation in terms of how Fed money is used.

Right now, the more money the Feds throw into the system, the more banks are using it to speculate on wild-ass trades. And that’s why we’re seeing massive swings, day to day in the overall financial markets. Huge banks with billions of dollars in Federal Reserve stimulus money are pouring it into the markets. That’s creating larger and larger waves, faster and faster trades.

Can these waves eventually overwhelm the entire financial system? Are banking and institutional traders larger than the entire stock market? Many people in the past would have said no, that’s not possible. And yet, we’re seeing it right in front of our very eyes. All you have to do is watch the drastic pitching and yawing of the DOW, S&P, bond markets, and gold prices.

Best solution is to either not be in the markets, standing on solid ground somewhere else; or, be sure to have a really really good life jacket on hand!

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