A really dire condition

The global stock market meltdown was put into motion by fear that a recession in the U.S. would reduce sales and earnings by suppliers everywhere in the world. Fear was especially pronounced in Japan and India. Fear of recession in the U.S. was already influencing the prices of the most high-tech of high-tech stocks in the Nasdaq, an irrational outcome.

The index chosen for the U.S. is the Dow Jones Wilshire 5000 (DWC), which encompasses just about every U.S. stock not on the pink sheets. Former Fed Chairman Alan Greenspan expressed a preference for this index, although it is not what most people think of when they say “the stock market” because it is so broad.

As of Jan. 18, the Wilshire was down 15.8 percent from its October peak. Similarly, the Eurotop 300 and the Nikkei 225 were falling, seemingly in sync with the U.S. market. The Nikkei 225 was down 27 percent from its February 2007 peak to the Jan. 21, 2008 close. A drop of 20 percent or more is generally considered a “bear market.”

The MSCI Asia Pacific Index was down 24 percent from its November peak. It shows three important Asian stock indices: the Bombay Sensex (India), the Hang Seng (Hong Kong), and the Shanghai Composite (China). On Jan. 21 each of these indices opened gap down, suggesting additional losses to come. The Hang Seng index, already down 31 percent from its October peak, is populated by seasoned traders who have seen opening down gaps and giant declines (e.g., the Asian financial crisis of 1997), but a large proportion of the traders in the Bombay and Shanghai markets are newcomers and amateurs, including Japanese retail traders. The Bombay market fell 11 percent within seconds of the opening bell and trading had to be suspended for an hour.

Both Asia and Europe were technically in a bear market and it’s fair to say the Fed cut rates to prevent the U.S. from following suit. The Fed statement does not mention stock prices, since the Fed — like most central banks — believes that it should not meddle in the conduct of free markets.

Nonetheless, Fed officials can read a chart as well as the next guy. It shows the three main U.S. stock indices: The S&P 500 (SPX), the Dow Jones Industrial Average (DJIA), and the Nasdaq Composite (COMP.X). It was already clear in December a support line was going to be tested.

Because fear of a U.S. recession is generally acknowledged as the sole trigger for the global stock meltdown, the U.S. is “responsible” for all these indices hitting the skids. Now let’s consider two things we think we know about the Fed. The first is that the Fed does not consider itself the “responsible” party for stock market performance. No single party is responsible. Responsibility lies with the multitude of participants. That’s its beauty and its curse. The curse part comes from the overall inability of the masses to judge price vs. value.

The second thing is the Fed can control only one thing — the fed funds rate. Its reach over a wider swathe of maturities is indirect and weak. That doesn’t mean it neglects the longer maturities in its considerations. In fact, the yield on the 10-year note is almost certainly its real aim.