June 23rd, 2013

It would be a mistake for the casual investor to think that the decline in the market this week was due entirely to Fed chairman Ben Bernanke’s comments regarding future Fed policy.  There was little that was not anticipated.  The Fed will continue to follow a rules based approach to its quantitative easing program, scaling back its purchases of government securities if employment improves or inflation increases above the Fed’s target of 2%.  Bernanke also reiterated that the Fed would increase its purchases if employment does not improve and inflation remains subdued.  So why the drop?

Shortly after the conclusion of each Fed meeting, Bernanke holds a press conference, where he issues a ten minute or so summary of the meeting and issues discussed.  He then takes about twenty questions.  At the start of this past Wednesday’s press conference at 2:30 PM EDT, the market was neutral as it had been all morning.  The Fed chairman was more specific about the anticipated timeline of the wind down of quantitative easing if the economy continued to improve.   Although he was essentially repeating himself, the voicing of a specific and concrete timeline evidently jolted some sleeping bulls who surmised that the party was over; in the final hour of trading the SP500 fell a bit more than 1% in the final hour.  For many traders, it was time to take profits from the eight month run up in prices.  “Quadruple witching”, a quarterly phenomenon that occurs when stock and commodity options and futures expire, was approaching.  The few days before this event usually see a spike in volume as traders resolve their options and futures bets.

With much of the Eurozone in a mild recession and slow growth in emerging markets, the rest of the world perked up their ears as the central banker of the largest economy envisioned an easing of monetary stimulus sometime in 2014.

Overnight (Wednesday/Thursday) came the news that the Shanghai interbank rate had shot up from about 4% to 13%, a rate so high that it threatened to seize up the flow of money between Chinese banks.  This bit of bad news from the second largest economy added additional downward pressure on world markets.  For some time, analysts covering China have been warning about the amount of poorly performing loans at China’s biggest banks.  The spike in interbank rates, prompted by the Chinese government, was an official warning to Chinese banks to be more cautious in their lending practices.

On Thursday morning came the news that jobless claims had increased, adding more downward pressure.  The SP500 opened up another 1% lower that morning and dropped a further 1.5% during the trading day. This classic “one-two” punch knocked the market down about 4%.  European markets fell about 5%, while emerging markets endured a 7.5% drop in two days.

In the past four weeks, there has been a decided shift in market sentiment.  When the market is bullish, it tends to shrug off minor bad news.  As it turns toward a bearish stance, the market reacts negatively to news that just a few months ago it largely ignored.

Over the past two months, long term bonds have declined 10% and more.  Here is a popular Vanguard long term bond ETF that has declined 12% since early May.

For the long term investor, periods of negative sentiment can be an opportunity to put some cash to work.