Don't panic -- but the market is heading for a much bigger fall

Posted Feb 27th 2007 6:10PM by Peter Cohan

Most market commentators will appear before the public and urge you not to panic. After all, they'll say, the market has been up 19% since last July and today's drop is just a 3% correction. Markets correct and the best thing to do is just stay the course. They'll point out that the market is not overvalued now -- noting that at a P/E of 16, stocks are far less overvalued than in 2001 -- the last time the market collapsed this much -- when its P/E was 26.

These calming voices have a vested interest in keeping people from selling their stocks and fleeing the market. If investors get scared away from the stock market, brokers' livelihoods go up in smoke. Unfortunately, there are five things going on in the global economy that should give investors serious pause:

China's stock market is like the NASDAQ in 2000. In China, the markets have more than doubled in the last year. Grandmothers are taking on second mortgages to day trade. The Chinese government is very nervous that these day traders could be wiped out -- leading to a political crisis and massive instability. So, over the weekend, the government took measures to limit trading velocity -- which led the Shanghai Composite to fall 8.8%.
The U.S. stock market is leveraged more highly than ever. As I posted yesterday, the U.S. stock market currently carries $286 billion in margin debt -- this is higher than the previous record set in 2000. As U.S. stocks fall, the lenders of that debt automatically sell stock to get their loan repaid. This creates a downward market spiral.
The Chinese and U.S. markets are more tightly linked than ever. The Chinese government holds about $350 billion worth of U.S. government debt which is denominated in dollars. Today, the dollar suffered its sharpest intraday fall for a single global session in over a year versus the yen which means that the value of those Chinese securities fell as well. As China gets more panicky about the dwindling value of those U.S. bonds, it will sell them to buy more stable currencies. This selling will not help U.S. markets and could force the Fed to raise rates to support the US currency.
Geopolitical instability is rising like sap in the spring. As I noted this morning, the Bagram bombing targeted at the Vice President and the U.S.'s massing of military assets near Iran are contributing to fears of a further military confrontation. And the oft-repeated comments about a spring offensive by the Taliban in Afghanistan could all contribute to higher oil prices, which are not good for the stock market.
A global credit crunch will lead to spasms of global selling. Today, fear of global credit defaults climbed to the highest level since The Dow Jones CDX North America Crossover Index was created in 2004. At some point all the banks and brokers issuing credit to Chinese and U.S. stockholders will want to get their loans repaid. If the markets in both countries keep dropping, the need to repay these loans will trigger waves of global stock-selling that will end when all the loans have been repaid. This global game of plunging market ping-pong could send both markets way down. If the Chinese market behaves like NASDAQ, it could lose two-thirds of its peak value and take years to recover.

Despite this, I feel much the way I did about the market after 9/11. A colleague in London asked me what I thought he should do about his portfolio. I told him that if he could wait five or 10 years, the value of his holdings would recover. In the short term, getting out, paying taxes and then picking a time to get back in would end up being counterproductive.

So don't panic, but make sure you have a bucket to puke in the next time the market drops 200 points in a minute as it did at 3 this afternoon.

Update: It's already the 28th in Asia now where Bloomberg reports that in response to the selling in the US and China, Australian and New Zealand market indices are dropping more than they have in four years. And so the global ping pong game continues.

Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm, He also teaches management at Babson College and edits The Cohan Letter.

Print this

Reader Comments (Page 1 of 1)

2-27-2007 @ 10:23PM

Father Richard Byrne S.J. said...

China is no longer run by a Geriocracy, young "Turks" are in charge. They will not let their money run through some fingers in the market.

2-27-2007 @ 9:37PM

craig said...

I would suggest that this is serious; if for no other reason that every analyst it seems is suggesting a healthy correction is at hand or is recommending a particular stock pick . Not that i know much, but the last time I was aggressively stating for people to get out was dec 99 (nasdaq) and I was getting insults and hate mail from all over the place. Stand aside til next Mar.(08)

2-27-2007 @ 11:11PM

IIM said...

International Institute of Management (IIM) released a new report warning about the U.S. economic health status. The report provides the following:
1. Uncovers the forces behind today's stock-market decline and the Chinese reaction to U.S. Economy's outlook.
2. A detailed analysis of the economic, social and geopolitical risks facing the U.S.
3. Forecasting the behavior of the U.S. and global markets.

The complete text of the report is available at:

http://www.iim-edu.org/u.s.economyrisks/index.htm

2-28-2007 @ 1:46AM

larry said...

my grandfather lost fortunes in 1929....I think margin calls will do two things worldwide..same as then....cause selling n panic, home mortgage defaults. 3 big banks could crumble ( i dont dare name them !!!)..best advice SELL before morning opening!...with big taxes owed by nations top 1 5 from last years winnings..record fed debt..payment imbalance..fuel crisis...( bad weather ahead!)...recession fears..etc etc,,no way the mkt can move upward!..so GET OUT!good luck..5.35 money mkts dont look bad for 07..lock it in QUICK

2-28-2007 @ 2:16AM

Steve said...

The China Olympics is next summer and she cannot afford to have a major meltdown in the stock market close to the Olympics. It is better to have a correction now. The Shanghai index is up about 3% and the U.S. market is going to open down but will bounce back nicely by about 100 points at the end of trading day on 2/28(month end). A 5% correction in the U.S. market before 2008 election will happen. Otherwise the market is healthy and there is no recession. I wish Greenspace would just keep his opinion to himself.

2-28-2007 @ 4:44AM

Shan322 said...

I realize I'm new to all of this, but I'm sticking. It's a bit dicey right now, but that's the name of the game. If everyone starts selling then it seems we really will be in trouble. I hope the other roller-coaster loving men and women will hang in with me for the ride. There are going to be a few small climbs and a couple big drops, but I have a strong feeling that, like a roller-coaster...the ups and downs will scare us and the ride will be over very quickly.

2-28-2007 @ 9:38AM

tayronachan said...

I'm all out. I'd recommed that everyone at least take some profits now. Lets face it, everybody posting here is probably small fry (that meaning having from $5,000 to $2,000,000 in the market). I know I am and capital preservation is the name of the game for us. If we do that we live to play another day. I follow most all of IBD founder William J. O'Neils' rules. I'll watch for at least a few weeks if not longer.

2-28-2007 @ 10:29AM

Bob said...

I place market analysts in the same category as weathermen. The no clue category.

2-28-2007 @ 10:47AM

Tom said...

Have no fear. The stock market will rebound. The bulls out number the bears. Besides the bulls have the Fed. Res. Chairman on their side. His bias is toward growth and avoidance of a recession. For months he has ignored raising interest rates despite inflation exceeding their unofficial "target". The bulls have to much skin in the game to allow the market to fall. They will feed it to lure in the small investors and get out when they are able to achieve a profit on their stock investments. The bulls have ignored risk for years, they will continue to ignore risk knowing the Fed. Res. Chairman will bail them out. Afterall Wall Street is too big to fail.

2-28-2007 @ 11:17AM

Melinda said...

Someone recently paid 2.35 million dollars for a small piece of cardboard with a dead baseball player's picture on it. It has a perceived value - the guy knows that there is another person out there with lots of money who is willing to pay more for it. If no one is willing to pay for it, then it is just an old piece of cardboard. Same thing with most stocks. They aren't worth anything unless someone will buy them. It's all about promotion and the media creating a market. But, people do have to put their money somewhere and the options are limited. So eventually, people always come back to the stock market.

2-28-2007 @ 3:59PM

Bob said...

I wish more people were selling. That's always the best time to buy. This correction helped to shake a lot of loose leaves from the tree that have to be raked up by others. The volatility in the market is what makes it so attractive.
I'm relatively new to trading individual stocks, having been invested in mutual funds for many years. Its a lot more work, but the rewards have been well worth the effort and a much surer way to achieve long term goals than any passive investment I've found.