Fear Strikes Out 2 Years After Flash Crash

by: Igor Greenwald

Sunday, May 6th was the second anniversary of the Flash Crash, when the Dow-- already deeply in the red-- extended its losses to 1,000 points in a matter of minutes as bids vanished, only to revive just as abruptly, escaping with a loss of "only" 3.2%.

The causes of the mini-crash, including the culpability of high-frequency computer trading algorithms, remain in dispute. But the episode does offer a useful reminder that the market is under no obligation to act rationally at any given moment, on any given day and-- often enough-- over considerably longer stretches.

People are under no such obligation either, but eventually common sense tends to prevail. That was the case Friday in France and Greece, as politicians who had toed Germany's line on the failed economic policy of austerity were turfed out by angry voters in favor of outsiders, even though the outsiders have not presented a credible alternative.

In France, Socialist Francois Hollande unseated President Nicolas Sarkozy, the first defeat of an incumbent in 31 years. Sarkozy's fate was sealed by unemployment pushing 10%, as the economy teeters on the brink of a recession.

In Greece, the mainstream parties that had acceded to the punitive "bailout" terms lost so much support in parliamentary elections that they now lack the votes needed to continue on the present course. The winners were a motley crew of communists, other leftists, and ultra-nationalists, all of them running against the cuts mandated by Europe.

Predictably, the markets' initial response was harsh: Dow futures were down as much as 130 points at their overnight lows. But this time, rationality seems to have returned sooner rather than later. European markets turned around early heavy losses to trade higher, tellingly led by gains in Spain and Italy.

The policies of austerity have proven disastrous to investors in the stocks and bonds of the growth-starved eurozone members. The prospect of change, however chaotic, simply isn't much scarier than same old same old, and only one of those two paths holds any promise of a recovery.

Hollande is not as radical as his campaign rhetoric implied—in fact, he's an economic moderate broadly within the European mainstream. He's also a staunch advocate for a united Europe, and so is highly unlikely to wreck the 60-year-old Franco-German alliance at its core.

At the same time, he has a clear electoral mandate to remind Germany of austerity's costs, and refocus it on the necessity of growth—not in five years after the hoped-for structural reforms, but soon, before capital flight and an unsustainably expensive currency bankrupt Spain and Italy.

As for Greece, it's already been written off— literally, on the books of European banks, and figuratively as the catalyst for a wider European crisis. The leverage of any government in Athens to seek improved terms from Europe is close to nil, while the costs of defiance in terms of failed banks and rampant inflation are sky-high.

So why isn't the U.S. following the European averages higher just yet? The S&P 500 is at a pretty important juncture near the bottom of its two-month trading range, following up its failed rally to new highs by knifing through its 50-day moving average.

Friday's plunge in response to a mildly disappointing jobs report was part of that, even though upward revisions for the prior two months brought the net new payrolls within a rounding error of the consensus estimate.

The bears' working theory seems to be that turmoil in Europe and the slowdown in China will derail the U.S. recovery. This recovery has been nothing to write home about as is, and is headed for the famous "fiscal cliff" next year, as tax cuts expire and automatic budget cuts take effect. In fact, exports account for just 13% of the U.S. GDP, and accounted for just one-third of the economy's modest recent growth, so it would take a real collapse in overseas demand to stop the economy from continuing to slowly heal.

Unemployment remains unnaturally high, and housing prices remain at historically low levels relative to income and rental rates. Whoever is in power come November will have powerful incentives to keep homegrown austerity at bay, the more so given Europe's bad example.

A recession is more than just two quarters of negative GDP growth. It represents a sea change in expectations about future demand (leading businesses to retrench and lay off workers) and the direction of asset prices (spreading fear though capital markets.) The Great Recession featured both in spades, and the economy has yet to regain its equilibrium. But the pendulum has certainly begun to swing toward a reversal to the mean, and those swings rarely stop a third of the way through.

This entire hedge-fund shakeout has barely registered for Home Depot (HD), trading just 2% below the 11-year high reached on May 2. Fortune Brands Home & Security (FBHS) is less than 2% below a record it set the same day, after raising its annual sales and profit forecasts. That's more telling about the economy's prospects—and the market's—than anything going on in Europe.

Disclosure: No positions