As North American stock markets went into a steep nosedive on Aug. 4, portfolio manager Oscar Belaiche refused to panic. Surprised by how fearful investors had suddenly become, he buckled down and started buying.
From his perch in a Bay Street office tower, Mr. Belaiche and his equity investment team at Dynamic Funds were opting to play the contrarian card. This was a moment they had been preparing for. Through the course of July, as U.S. President Barack Obama and a dysfunctional Congress stumbled through rancorous negotiations to raise the debt ceiling, Mr. Belaiche had decided to stockpile some cash. He had a hunch that when a deal was reached, the result would not sit well with investors.
He was right. But even a seasoned money manager who lived through the Asian meltdown, the technology crash and the financial crisis of 2008-09 could not have been totally prepared for what was to come.
At about 8 p.m. on Friday evening, rating agency Standard & Poor's dropped a bomb. Hours after traders had gone home, the United States, the world's largest economy and the centre of the financial universe, lost its triple-A status.
The resulting uncertainty spread like a burning bush over the weekend. Because money managers could do nothing else, they worked through the myriad permutations of what could happen when the markets finally opened in Asia on Monday morning, or Sunday night on the east coast of North America. Working from home, Mr. Belaiche created a "shopping list" of stocks to buy if markets tanked on Monday. When they did, he and many other portfolio managers sprung into action.
By the end of trading on Friday afternoon, the S&P/TSX composite index had posted its best week in more than a year, up 3.1 per cent. But the path there involved stomach-churning volatility. In the U.S., the Dow Jones industrial average, which ended the week with a small loss, moved more than 400 points four days in a row this week – a record. Over all, most major equity markets are down at least 10 per cent off their recent highs; Germany's benchmark DAX index has fallen nearly 20 per cent since July 7.
So far, investors have struggled to make sense of the freefall. It appears they haven't been reacting to one specific event, but a mishmash of worries: the U.S. downgrade, Europe's worsening sovereign debt crisis, a slowing world economy, even concerns about China's prospects.
It is, Mr. Belaiche says, "the correction with no name." But perhaps that's because underlying all these factors is the fragile state of mind of investors, who remember the 2008 crash all too well and are fearful of a repeat.
"People are afraid of being afraid, the way they were in '08 and '09. That left a lot of scar tissue," says John Schumacher, who now is a partner at hedge fund company East Coast Fund Management Inc. and a former senior executive at Bank of Nova Scotia's securities arm. On Monday morning, as stocks began a downward spiral, Mr. Schumacher's daughter sent him a text message. "Is it going to happen again?" she asked.
How and why the fear spread
For all the confusion around the day-to-day trading, no one can say the possibility of a correction never existed. Stocks markets have soared since Ben Bernanke hinted at a second round of quantitative easing during the annual Jackson Hole conference in Wyoming last August. Spirits were so high that not even a devastating Japanese earthquake could dampen the mood for too long.
Yet beneath the surface, the U.S. economy was beginning to stall and Europe's debt problems kept flaring up. It became clear that Greece would need another bailout and systemic reforms, all of which would affect European banks that hold Greek debt.
Those concerns weighed on investors as the debt ceiling talks kicked into high gear in July. Still, they remained optimistic and North American markets were flat for the month. That all changed until President Obama spoke in the Brady Briefing Room of the White House late on Friday, July 22. Furious that Speaker of the House John Boehner had walked away from the debt ceiling talks and would not return his phone call, he hastily put together a press conference to cast shame on Republicans.
Investors got the message. The following Monday, equity prices began to fall. The slump continued until both houses of Congress passed a debt ceiling bill, but even then people weren't pleased. That's because the U.S. "gave birth to a runt," said Leigh Pullen, chief investment officer at QV Investors in Calgary. The compromise package had very little in the way of specific, immediate cuts, and there was a consensus that later cuts would be subject to political calculations.
Yet it was enough to hold off panic – at least until bond investors began dumping Italian and Spanish bonds, stoking concern that the euro zone's third- and fourth-largest economies would be ensnared in the same vicious spiral that forced Greece, Ireland and Portugal to seek bailouts. Panic rippled through global markets.
"You had the charcoal, you had the sulphur, and somebody lit a match," Mr. Pullen said.
This fear was only exacerbated by S&P's downgrade of the U.S.'s debt rating on Friday evening, creating what David Denison, head of the Canada Pension Plan Investment Board, dubbed the "weekend of uncertainty".
"On Sunday, you could have spent the entire day on conference calls learning about what it meant to have the U.S. downgraded," said Dan Chornous, chief investment officer at RBC Global Asset Management. "So we all went on a few conference calls, then went back to our families."
For Mr. Denison and other experienced market players, the situation brought to mind 1987. In the week leading up to Black Monday, stock markets had been extremely volatile. When trading resumed after a restless weekend, all hell broke loose.
That a similar situation played out this time around surprised even people like Mr. Pullen, who expected a correction. During a market rally last September, he warned that "a levered economy and a levered equity market create conditions for swift recoveries based on changes in mood ... but fundamentally aren't supported." But he still wasn't quite prepared for the force with which American investors hit the sell button the first Monday after the downgrade.
Mr. Pullen had seen this type of fear only once before in his life: following August 8, 1974, when Richard Nixon resigned from office. In an instant, ever-so-proud Americans had become morally deflated, and in their despair, they sent the S&P 500 plummeting.
"Americans had lost confidence in themselves," Mr. Pullen argues. And he believes the same was true following the S&P downgrade.
The rapid selloff put everyone on edge. Just before the closing bell on Monday, stocks were being sold at an uncontrollable velocity, making the last minutes of trading the most chaotic.
After catching their breath in the few hours between when North American markets closed and Asian markets opened, investors turned their attention overseas. RBC's Mr. Chornous said he got up every couple of hours to keep an eye on these markets and to check on the American stock market futures, which indicate where the markets here are likely to open the next day.
Some investors decided against making major moves. "I'm a little bit puzzled that people have been so short term in their thinking," said Leo de Bever, chief executive officer of Alberta Investment Management Co., the province's largest pension fund.
"We didn't need S&P to tell us that the U.S. had some debt issues," he said. AIMCo simply opted to protect its riskiest exposures, and did a little bit of buying. "In a market like this, there really isn't much you can do because it doesn't seem to be driven by any kind of rational response to anything."
It's not 2008 again
Yet in all this chaos, there is a silver lining. Despite the fears of a repeat of 2008, money managers say they see big differences between today's environment and the fall of 2008, when it felt like the global financial system could keel over at any second.
The 2008 collapse was driven by a fear of the unknown. The world's biggest banks had hundreds of billions dollars worth of "toxic assets" tied to the U.S. housing market, and no one knew what they were worth. When drafting emergency programs to save the banking sector, the U.S. government simply threw out the $700-billion figure as a best guess of how much money was needed to solve the problem.
This correction is also rooted in serious problems – but, by contrast, most of problems are well-understood. Investors can at least wrap their mind around things like cuts in U.S. discretionary government spending and European austerity packages. The financial system and the credit markets, so far, seem to be functioning normally.
On Bay Street, there are other signs this is not 2008 all over again. When markets tumbled three years ago, there was an immediate shift away from block trades, which are large institutional trade orders that can be as large as 500,000 shares of a given company. Typically, traders who can't find a buyer or seller for a certain order will buy the block themselves, putting their brokerage's balance sheet at risk to any price movements. When Lehman Brothers collapsed, these proprietary trading books were effectively shut down. That hasn't happened this time around and some bigger orders are still getting placed.
Different trading ideas are also still being pitched to money managers. In 2008, no one even tried to put forward possible trade ideas (i.e. buy large caps, buy for yield) because everyone had gone into shell-shock mode. Not so today. Pitches are still being thrown around, and in Canada at least it's clear that some people are acting on them.
Still, there are very prevalent fears. Chiefly, no one is quite sure if interbank lending in Europe will dry up, a terrifying thought because a lack of liquidity is what tore apart the financial system in 2008. To build confidence, some people have argued for a European program in which hazardous debt is removed from the banks' balance sheets so that investors can stop trying to guess whether banks are in financial trouble.
There is also the threat that China will stop buying U.S. Treasury bonds. Miraculously, even after the U.S. was downgraded, investors kept flocking to U.S. government debt, sending its yields plummeting to depths never seen before. But there are warning signs that China, the biggest foreign buyer of these bonds, could budge. The day after the U.S. was downgraded, the Chinese government released a statement through its official Xinhua news agency: "The U.S. government has to come to terms with the painful fact that the good old days when it could just borrow its way out of messes of its own making are finally gone."
For now, some calm has returned. But the fear still lurks under the surface. The earthquake may be over for retail investors, Mr. Belaiche said, but if the ground starts to tremble, "the first thing [they're] going to do is run."
With files from reporter Boyd Erman