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Beneath the Market's Swings, Some Real Cause for Worry

In the never-ending market battle between fear and greed, fear is clearly winning these days, but not without reason.

New York Stock Exchange trader
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New York Stock Exchange trader

Contagion from European debt problems, the instability of U.S. public financesand an ever-weakening economic outlook all have contributed fundamental underpinnings to the wild market swings.

So whether this equals, falls short of, or exceeds the financial crisis of 2008hardly seems to matter—investors are afraid, very afraid, and the question as much as anything in the minds of many market pros will be what soothes that fear.

"Everyone’s soul has been tested and tested again in the past week," hedge fund manager Dennis Gartman wrote in his daily newsletter Thursday. "The abject randomness of the past several trading days has been extraordinary and we can honestly say that in our 35-plus years of trading we’ve never seen anything quite such as we’ve seen recently."

At least that part sounds like 2008.

Superlatives to describe market conditions were in plentiful supply three years ago when Wall Street looked like it was blowing up and taking the entire financial system with it.

But the crisis essentially began with murmurs that grew to a crescendo about the stability of the Street's most notable names—at first the seemingly indestructible Bear Stearns.

Then, like now, rumors of Bear's lack of liquidity were dismissed initially, then seemed to feed on themselves until the investment bank became crushed under a campaign by short sellers. The shorts spread the word of troubles at Bear, leading to more short sellingand ultimately a refusal by its trading partners to provide it the overnight cash essential to the bank's ability to do business.

It is the dismissal of the rumors initially that sounds most like the current story.

Addressing stories that French banks were about to crumble, Gartman wrote: "To believe that the banks in France are insolvent and that their demise is imminent is almost certainly wrong, and the rumors are ever more certainly overblown to a very, very large degree."

Three years later, though, and it's not just chatter about byzantine investment banks. Now there are economic frailties to underscore the weakness that has sent markets tumbling.

Gone nearly unnoticed Thursday, for instance, was a report showing the U.S. trade deficit swelling to $53.1 billion, more than 10 percent higher than projected. Sometimes, trade deficits can widen for good reason, like higher consumer demand for imports.

But in this case, the imbalance was because other countries simply weren't buying American-made goods.

Exports fell by a staggering 2.3 percent from the previous month, as growth in exports with US free-trade partners Canada and Mexico—under the umbrella of the North American Free Trade Agreement, or NAFTA—fell to 8.5 percent and 18.7 percent in June from 14.3 percent and 25.5 percent in May.

The overall story in the trade imbalance is that U.S. gross domestic product (GDP), already well below normal for this point in what is supposed to be a recovery, will weaken more. Nomura Securities said it was cutting its tracking estimate for second quarter GDP, already at an anemic 1.3 percent, "several tenths" lower.

"Looking ahead, the global slowdown in manufacturing activity could drive down exports further, and the normalization of U.S. operation by Japanese automakers could increase parts imports," Nomura economist Aichi Amemiya said in a note. "Against this backdrop, we doubt the trade balance will shrink significantly over the next few months."

Trade, of course, is only one metric.

U.S. banks, despite a persistent narrative of being well-capitalized and without major exposure to the European debt crisis, have gotten pummeled lately.

Analyst Dick Bove at Rochdale Securities says he knows why: More restrictive capital requirements and near-zero interest rates set at the Federal Reserve that make lending neither easy nor lucrative, a trend that will make it difficult for the economy to grow.

"If one thinks through these limitations it can be seen that banks must shrink their balance sheets and change their business patterns to maintain their profits. What they are unlikely to do is to expand their lending activities in order to grow the economy," Bove wrote in a lengthy banking analysis Thursday.

"However, the Federal Reserve is suggesting that the economy is unlikely to grow," he wrote. "If the Fed is prescient, then banks are facing higher loan losses, lower loan volume, and reduced margins on a wide array of banking products. The outlook is not appealing."

In fact, Bove insists that what is happening now is merely a continuation, and not a second iteration, of what happened in 2008, as losses moved from private balance sheets to the public.

"Even though the United States is able to both print and borrow money, it is as bankrupt as the Europeans," Bove wrote. "Covering deficits and paying debt with borrowed funds, some of which is newly printed, does not constitute meeting debt service requirements."

The worries in the market, then, seem to be as substantive as they are superstitious that a crisis lurks somewhere, even if investors aren't able to pinpoint exactly where.

Asked whether the market was merely having a knee-jerk reaction to fear or taking a more careful measure of fundamentals, Rick Bensignor, chief market strategist at Dahlman Rose in New York, said, "Can I answer both questions 'Yes'?"

"There's paranoia and there are real reasons," he said. "There's been a real repricing of risk in the markets."