What's Behind the Selloff: Panic Is Turning to Despair

After being in panic mode the past few weeks, investors are now wallowing in despair.

Stock markets tumbled around the world Friday as investors moved to liquidate risky positions. Mounting evidence of a global recession, born of the worst financial crisis in 80 years, kept most markets volatile.

Global Markets
Global Markets

US stock indexes fell over 3 percent, though not as much as feared earlier in the day. European stocks tumbled 6.5 percent and Japan's Nikkei plunged 9.6 percent.

The US dollar surged to fresh two-year peaks versus a basket of currencies as dismal economic data from Europe heightens fears of recession.

The yen soared to multiyear highs versus dollar and euro on ensuing risk aversion, while British pound suffers biggest one-day drop against U.S. currency since September 1992, according to Reuters data.

Oil plummeted more than 7 percent to less than $63 per barrel, while commodities from copper to zinc, sugar and coffee were battered by sharp selling.

“The market in general is people throwing in the towel,” says Michael Cohn, chief market strategist at Atlantis Asset Management. “Bear markets go from denial to panic to despair, and we’re at the despair point, which I’m hoping is the last of the stages.”

What's behind the selloff? Investors around the world are ignoring the good news and focusing on the bad. And there's plenty of that to go around. Amid all the gloomy economic data and disappointing earnings, economists and market pros are increasingly convinced that the US and the rest of the world are headed for a painful recession.

For Investors

“We’re so deeply oversold I would think the market would start to recover and rebound pretty significantly,” says Chip Hanlon, president of Delta Global Advisors. “But I think the market’s deciding that this is going to be a prolonged and painful recession. I think that’s a fair conclusion, so were getting these fits and starts.”

To be sure, a handful of the companies that posted strong earnings have seen their shares enjoy mild rallies. But most are like McDonald’s , which beat analyst estimates for the quarter and then watched its stock fall after a downbeat forecast for the rest of the year.

“Even if they report good numbers, it’s the guidance going forward,” Cohn says. “As a CEO in this type of environment, if you paint a rosy picture going forward you’re going to be thrown in jail.”

Another reason stocks can't hold rallies is that there is substantial selling pressure from hedge funds facing redemptions.

Making sense of this market. Watch video at left.

Hundreds, perhaps thousands, of the investment pools are expected to drown this year as they face intense pressure to unwind before the end of their fiscal year on Oct. 31.

“There’s nobody on the other side of these trades,” Michael Kresh, president of M.D. Kresh Financial Services, says of the hedge fund situation. “The reality is there’s nobody willing to come up to the plate and buy until they feel this is all over...Every time we get a nice up trade there’s a possibility that somebody needs to liquidate and they’re liquidating toward the end of that up day or the next day.”

That was in evidence in each of the past two weeks, when Mondays brought strong moves higher in stocks that eroded as the weeks went on.

Fear-buying has been substantial, with the Volatility Index moving into uncharted waters, while bad earnings reports have served to undercut rallies and strong earnings have had little impact.

“It’s nothing to do with what we’re seeing in earnings,” Kresh says.“What we’re seeing is a standard pattern. If you take financials out of the picture, most companies are meeting or exceeding earnings expectations. But it doesn’t seem to help. Fear is the primary driver here.”

Once the hedge fund situation unwinds, there will be clearer picture of exactly how deep a problem the recession will pose, Kresh says. Cohn, meanwhile, is awaiting the impact of the government’s additional stimulus efforts.

Hanlon is making tepid moves at buying into the weakness, using exchange-traded funds like the ProShares Ultra Small Cap and the ProShares Trust Ultra QQQ. The SAA moves up 2 percent for each 1 percent gain in small gaps, while the QLD gets the same return for a move higher in the Nasdaq.

Hanlon bought both funds with fairly strict stops put in to guard against steep drops.

“I’m in the camp that believes we can get (a rally) at any time,” he says. “I’m trading on the long side, but not with any conviction.”