Be Afraid

Why the markets are tanking.

A trader on the New York stock exchange

What is it with August? In August 1998, the emerging debt crisis that eventually took down Long Term Capital Management began, and in August 2007 the subprime-mortgage crisis began showing itself. Here we are in early August 2011, and the markets are tanking. On Wednesday, the Dow Jones Industrial Average snapped out of an eight-day losing streak and posted a teensy gain. Then on Thursday, the plunge—was it ever a plunge!—resumed, with the Dow closing down 513 points. That’s the worst performance since the terrifying fall of 2008. Overnight, Asian stocks fell, as did European stocks.

The news this morning that the economy added more jobs than were expected—117,000, lowering the unemployment rate from 9.2 percent to 9.1—provided brief respite. But by late morning, stocks were headed south again. The turmoil will likely continue. We’re being hit all at once by a European debt crisis; a hangover from Washington’s debt-limit fight; growth figures that indicate that the economic recovery, which was supposed to get us out of our own debt trap, is even weaker than we thought; and a strong suspicion that our trillion-dollar budget deficit leaves the government unable or unwilling to provide much stimulus this time out. (My repetitive use of the word debt is intentional, because debt is the heart of the problem.)

The worst part of the current mess is, of course, Europe. It’s easy to have been fooled by the long periods of calm between crises into thinking there was calm. After all, the problems in Greece first hit the news well over a year ago. But if you think back to the onset of the financial crisis in the fall of 2007, the most disconcerting thing was the fits and starts with which it manifested itself before everything went blooey in the fall of 2008. There were periods of panic—like with the near bankruptcy of Bear Stearns—that were followed by eerie quiet stretches. Just as there was a fix for Bear, there was a fix for Greece—in late June, the European Union agreed to another bailout. But the crisis marched on inexorably.

Every country in Europe has a different issue, but the underlying fear is that the problem is solvency more than liquidity. If that’s true, then providing liquidity, as the EU has done, will work as a painkiller, but it won’t fix the underlying sickness. That might be why every bailout, from Greece to Ireland to Portugal, has failed to comfort the markets for good. Growth in Europe has slowed sharply, and the tremors that began in Greece have now spread to Italy and Spain. (The situation is particularly acute in Italy, with bank stocks falling to the depths of the post-Lehman crisis; there are rumors that a restructuring is imminent.) Hedge fund manager David Pesikoff of Triangle Peak Partners makes the disquieting observation that Iraq is now judged as safer than Italy and Spain (based on the price of insurance to protect against a default within the next five years).

Italy and Spain tell us to stop worrying, they’re fine, but so did Greece, Ireland and Portugal—right up until they weren’t. As part of the last Greek bailout on July 21, the European Union put in place a plan to alleviate financial stress in other countries by having the European Financial Stability Fund—sort of a TARP for Europe—buy bonds. But it’s not clear that Europe has sufficient funds or political will to do a massive bailout.

One source of mine likens the EFSF to the abortive efforts in the fall of 2007 to fix the burgeoning crisis in the United States with a giant structured investment vehicle, or SIV, that would buy bad debt from banks. He calls the EFSF a “self-inflicting attack vehicle” because the bonds it issues trade for less than do bonds issued by Germany, the strongest member of the EU. When investors seek safety, they will buy German bonds, not EFSF bonds. That, in turn, will push down the price of EFSF bonds, thereby lowering the price of the very credits that the EFSF is trying to rescue.

Europe is a problem for the United States for three big reasons. One is that the unrest that inevitably follows economic trouble is never good for anyone. Another is that a good chunk of the earnings of U.S. companies—roughly a quarter of the earnings of all companies in the S&P 500—come from Europe. A third is that problems in the banking system might be contagious, in part because European banks fund themselves in U.S. money markets. The most recent measure I’ve seen is that more than 40 percent of U.S. money market funds are invested in European bank debt.

The big fear is that this funding isn’t stable, and there are some reasons to believe that might be true. Yesterday, the Bank of New York announced that it was going to charge large depositors to hold their cash. BNY’s explanation was the “massive dollar deposits it has received over recent weeks.” What this means is that large investors would rather receive no interest and have their deposits insured by the Federal Deposit Insurance Corporation than take any risk whatsoever. That may be a worrisome sign for the stability of money market funds.

On Aug. 4 the Wall Street Journal pointed out that if European banks can’t fund themselves with U.S. dollars any other way, they might avail themselves of a program between the Federal Reserve and the European Central Bank in which the Fed makes U.S. dollar loans to the ECB so the ECB can lend to European banks. (This was used extensively during the 2008 crisis.) But it’s not clear that this is risk-free to the United States. Because the ECB has been buying the bonds of weaker countries in an effort to support them, it’s no longer certain that the ECB itself is rock solid. While official sources tell me that this isn’t even close to being a problem, the pessimists I talk to are worried. (Worry is what pessimists do, of course.)

What’s going on isn’t all Europe’s fault. We have our share of problems here. The resolution of the Republican-manufactured crisis over the debt ceiling didn’t resolve anything. As a result of government spending after the 2008 crisis, we have way too much debt. But if we move to cut our debt too quickly, economists say we risk crushing whatever nascent economic recovery there is.

Which gets to another problem: Recent data make it look more and more as though a recovery is just wishful thinking. Last week, the government released revisions to U.S. GDP data going back years. They showed that the recession was even worse than anyone thought and that growth in the first half of the year was barely positive. The numbers, says David Zervos, the head of fixed income strategy at Jefferies, “forced a major rethink for everyone” who thought we were on our way to a sustained recovery. Consumer spending, which is usually a good chunk of GDP, has been virtually nonexistent this year as a contributor to GDP growth. And according to Pesikoff, trucking tonnage, which serves as a measure of general economic activity, has stalled. “This is all to say the economy is stagnating,” he wrote in his most recent weekly newsletter.

Bulls cite strong corporate profits as a reason to be optimistic. But most of that has come from cost cutting—all those lost jobs!—not from real growth. I’m not sure how sustainable corporate profits are if the economy doesn’t recover.

Speaking of bulls, there is actually a surprising amount of sanguinity out there. The Investors Intelligence poll, another favorite of those who like to measure sentiment, shows that there are more bulls today than there were in June. The “buy the dip” mentality is alive and well, as is the belief that there’s a “Bernanke Put”—that the Fed chief will find a way to bail us out. I would really, really like to believe this. But we may be reaching the limits of the government’s power to rescue the economy.