How Irrationality Has Sparked the Dow's Triple-Digit Plunge

Down go the markets on renewed fears over an end to quantitative easing. The Dow Jones Industrial Average (DJINDICES: ^DJI  ) has fallen sharply, diving 120 points, or 0.78%, as of 2:25 p.m. EDT. Most stocks are in the red, but today's dip is a reminder that easing has to end sometime -- although Wall Street has yet to accept that truth. Here are the stories you need to know about on the Dow's down day.

Volatility takes the day
The CBOE Volatility Index (VOLATILITYINDICES: ^VIX  ) , or the market's "fear gauge," has shot up 5.4% today as part of a nearly 27% run-up over the past month. While Federal Reserve chairman Ben Bernanke has warned that slowing quantitative easing could slow down the economy's recovery, investors shouldn't panic over a draw-down of bond-buying. The Fed can't keep up stimulus forever, and while easing has helped some sectors of the economy regain their footing, eventually "QE infinity" will have to come to end. Prepare for more volatility ahead as Wall Street comes to grips with that eventuality, but don't panic and divert from long-term goals. The central bank won't jerk stimulus out from under the feet of the economy, but rather taper it off over time. That's nothing to fear.

Those knee-jerk sentiments from Wall Street have sent Home Depot (NYSE: HD  ) shares plummeting 2.6% today. No doubt stimulus has played a part in housing's rebound from its recession lows, but Home Depot has performed well for investors lately. The company's standout first-quarter earnings and optimistic outlook for full-year profit are good signs for this stock's future, and so long as housing continues to tick up, there's no reason to doubt Home Depot now.

IBM (NYSE: IBM  ) shares have also fallen to the bottom of the Dow today, down 1.6%. The firm purchased cloud-computing company SoftLayer today in what is reportedly a $2 billion deal. Cloud computing has taken off recently, and IBM's purchase should further cement Big Blue as a key player in this growing industry. Amazon has already thrived on the back of the cloud-computing industry by offering public clouds to smaller and midsized businesses, but IBM could use its own public clouds to offer its services to corporate customers.

Fortunately, a few Dow members are beating the pack today, and Merck (NYSE: MRK  ) leads the index with a 2.9% gain. The firm's melanoma drug lambrolizumab posted strong clinical data at the American Society of Clinical Oncology this past weekend, reducing the growth of tumors in late-stage melanoma patients by 38%. Merck has struggled with falling sales as a result of patent expirations -- particularly on its top-selling therapy, Singulair -- and if lambrolizumab can pass regulatory hurdles and live up to its blockbuster expectations, the drug will go a long way toward firming up Merck's future.

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  • Report this Comment On June 04, 2013, at 2:53 PM, banmate7 wrote:

    Dan, nobody has been able to answer my queries on how exactly does QE support the financial markets. The fed buys X t-bonds from banks. Bank books now have -X t-bonds but +X reserves. Central bank books now have +X in both t-bonds & reserves.

    The money on bank reserves should be lent out...but from what I can tell, it isn't. It's mostly staying on bank sheets. It certainly is not being lent out to buy stocks & other equity instruments. Some is being used to refinance mortgages to qualified borrowers at lower rates, which seems to be a positive development, fostering deleveraging.

    A residual QE effect effect is that low interest rates compel people to enter the stock market to search for yield. But this would be the case if the fed were buying government bonds.

    Again, I see no compelling evidence that QE is propping up markets. Corporations have $2 - $4 trillion on balance sheets, so they don't need additional liquidity or stimulus. Earnings seem real to me, which is why I remain all in on the North American economy.

    My main academic black hole right now is in understanding how the fed is up by 2X through QE, per what I stated earlier in this post. The fed has t-bonds and reserves up by X each, even though it bought only X t-bonds from the banks. I'm confident the fed will find buyers when it has to sell these assets, but I'm not sure what to make of this 2X factor...if anything at all.

    Any thoughts? I haven't been able to find anything definitive here.

  • Report this Comment On June 04, 2013, at 5:50 PM, luckyagain wrote:

    banmate7 - interesting comments.

    I will take a shot at what some people believe about the Fed and its actions. From the comments that I have read, some people believe that when QE ends, that interest rates will shoot way up. This rapid rise of interest rates will drive down desire to buy stocks for their dividends and the stock market will have a large drop. This large increase in interest rates will hurt borrowers. Since the US government is the largest borrower in the world, the US government will have to have a huge increase in taxes to pay for the borrowing cost. Result a recession/depression along with a possible inflation.

    My expectation are different. I expect that the Fed will ease up on QE over a number of months/years and the economy will adjust to the higher interest rates because there is so much money being held by companies. The Fed will slowly sell off the Federal bonds instead of just dumping trillions of dollars of bonds at once. Interest rates will stay low. Of course I could be wrong.

  • Report this Comment On June 05, 2013, at 3:04 PM, banmate7 wrote:

    I by and large agree with you. I think your most salient point is about controlling volatility, especially interest rates...which is why I believe they will rise very slowly, allowing the economy time to adjust.

    I believe that during the secular bull market from 1982 - 1999, interest rates ranged from about 6% - 15%. It did linearly decline during this time, but within there were up & down cycles. The point is that the stock market can prosper even when there is compelling bond yield. This just tells me that age appropriate portfolio balancing will normalize again.

    There are 2 big question marks in my mind:

    1) Can the fed find bond buyers? I believe it will, that the US will get back on sound footing.

    2) Can we reverse our culture of debt? In my opinion, leverage is what killed us. At some point, we need to pare down national debt, household debt as well. To your point about rising rates, this is a crucial factor, as rising rates can have less impact if we correctly deleverage. The wild care here is that this is so dependent on human behavior: with government, main street, and wall street.

    In summary, I share your general forecast. I'm staying all in on North American blue chips. Our companies are the most innovative & dominate every supply chain on the planet. Emerging domestic energy & 3D printing promise to reinvigorate our manufacturing base.

    Most of all, I will keep faith with value investing fundamentals that have kept me in good stead in 25 years of investing, good times & bad.

    Fingers crossed.

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