Stocks rebounded on Thursday and will try to hold a small gain for the week. Stocks have moved lower since reaching a new S&P 500 Index high on August 2, losing ground in the previous two weeks.
The Federal Reserves quantitative easing policy fueled hot money flows into emerging markets over the past few years. Many investors expected the U.S. dollar to weaken indefinitely, with U.S. interest rates staying low for the foreseeable future. Now, with the possibility of asset purchase reductions, the flows are moving in reverse as investors seek to repay their dollar loans.
Investors didn't learn their lessons from previous crises though, and Asian investors and developers levered up, in some cases using U.S. dollar denominated debt. Those with dollar debts are most at risk as the U.S. dollar strengthens and their domestic currencies collapse, as we have seen happen in India and may be beginning to happen in Indonesia. Those who didn't borrow dollars are at risk as well, with interest rates jumping higher. Unlike the localized Asian Crisis of 1997, odds are a serious emerging market crisis would span the globe, from Brazil to Turkey. A crisis isn't clearly underway yet, but the behavior of some currencies such as the Indian rupee warrants close attention.
In contrast, the U.S. economy remains stable. Housing data has been strong, even as home building and real estate stocks are hit by traders making an interest rate trade. The U.S. remains relatively insulated from emerging markets, though multinational earnings will suffer if a wider crisis erupts. Still, the domestic U.S. economy would likely benefit from inflows of capital that will keep U.S. interest rates relatively low compared to foreign nations, with or without the Fed's taper. As for the taper beginning in September, it looks less likely after two weeks of declines and emerging market instability. The weaker markets stay in the coming weeks, the less likely we'll see a September taper and the more likely stocks will rally strongly after the Fed meeting next month.
Thursday's glitch at the Nasdaq was an uneventful delay in trading, but it should remind investors that there are many risks in trading. High-frequency trading is a relatively new phenomenon in the markets, in terms of the amount of trading activity and volume passing between computers. Only last week, the Chinese saw two major trading errors, one in the stock market and one in the bond market, triggered by the same firm. Were such a delay in trading to occur in the midst of a bearish period, the result could well be a much larger panic. The flash crash of May 2010 came in the midst of a bearish period for stocks, with the Greek crisis in full bloom, BP's Gulf disaster and a selling in stocks. If the markets come under major stress again, we should be prepared to see similar technical problems.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.