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Back on the brink? A guide to what’s happening in the markets.

A chart displayed above the floor of the New York Stock Exchange displays the day’s trading in New York October 15, 2014. (REUTERS/Lucas Jackson)

U.S. investors have just received a humbling lesson in how tightly knit together the world has become.

Take a virus from Liberia, a Saudi oil discount, a disappointing German export statistic, a sales tax increase in Japan, demonstrations in Hong Kong and tensions with Russia. Toss in some bad bets by big hedge funds and financial houses on a mega-takeover deal that went sour in Britain, crude oil prices that suddenly plunged, and bond prices that unexpectedly rose.

Mix these ingredients together with investors who have ignored a slew of warnings about overpriced stocks. Then stir.

The result: Financial tremors large enough to rattle world markets. During a rollercoaster of a week, an average of more than a billion shares a day were traded on the New York Stock Exchange. On Wednesday alone, the Dow Jones Industrial Average plunged by 460 points before recovering much of the drop in afternoon trading and ending the day down 173 points. The Standard & Poor’s 500- stock index nearly wiped out its gains for the year.

“October can be a spooky month for stock investors,” Ed Yardeni, president of Yardeni Research, wrote to clients on Thursday morning. And this time, he said, “my hunch is that Halloween might have come earlier than usual.”

An element of stability was restored by Thursday and markets closed flat, thanks in large part to a few well-timed leaks and reassuring comments by Federal Reserve Board chairman Janet Yellen, described by one analyst as “the fairy godmother” of the stock market. On Friday, a jump in housing starts and strong earnings reports from General Electric, Honeywell and Morgan Stanley lifted spirits and the markets finished recouping most of their losses for the week.

Nevertheless, the lesson, said Kathy A. Jones, fixed income strategist at the Charles Schwab brokerage firm, is that “you can’t just pay attention to your own market. You can’t just focus on XYZ. It will be affected by everything else going on.”

Several moves helped trigger the week’s events. One was the decision Tuesday evening by pharmaceutical firm AbbVie to reconsider, and ultimately drop, its $54 billion takeover bid for the Irish drug maker Shire because the Obama administration wants to crack down on mergers designed to avoid taxes by moving headquarters abroad. The price of Shire stock crashed, opening Wednesday morning down 23 percent. The downdraft caught some big names and probably cost two of them hundreds of millions of dollars overnight. One was BlackRock, whose funds owned 6.7 percent of the company. Another was John Paulson, whose hedge fund owned 4.8 percent.

Many hedge funds borrow money so that they can leverage profits as they ride merger waves like that one. But borrowing money can magnify the pain of bad investments, and many of those funds may have been selling stocks or bonds to cover borrowing costs and margin calls on other investments, analysts said.

“They’ve been bragging about these positions,” said one Washington-based manager of institutional funds, “and now all these smart-ass hedge funds have been caught with their pants down.”

Chaos in bonds

Other financial firms were also squeezed by wrong bets on U.S. bond prices. For years investors have been anticipating a drop in U.S. bond prices, which would go hand in hand with an increase in rock-bottom interest rates. Every utterance by a Fed official is scrutinized for a sign of a rate increase.

But this week a different plot played out. The International Monetary Fund lowered its forecast for European growth. Then the head of the European Central Bank, Mario Draghi, who has vowed to defend the euro, said he needed help from fiscal policy makers. When Germany’s finance minister urged continued budget discipline instead of U.S.-style quantitative easing, that exacerbated fears that the euro zone might totter into recession and deflation. Investors fled European stocks and bonds and took refuge in U.S. Treasury bonds; on Wednesday, bond trading volumes surged, with $924 billion worth of U.S. Treasuries being exchanged, according to ICAP PLC, a brokerage firm. Bond prices rose and yields, at one point, fell below 2 percent.

Jones said that there is less liquidity in the bond markets than in earlier crises because banks have pared back bond trading operations — and at one point Wednesday bonds hit an “air pocket” and prices bounced wildly, with yields fluctuating more than anytime since a handful of days in late 2008.

In an effort to calm markets, the San Francisco Fed president said that if the economy weakens again, he would be open to another round of bond and mortgage purchases by the Fed — though such quantitative easing is being phased out. That is the kind of support Draghi said he could use to bolster Europe’s flagging economies.

However, Jones said, “we’re learning that there are limits to what the central banks can do.”

Meanwhile, the oil market was also behaving unexpectedly. Over the summer, financial players buying oil as an investment — as opposed to oil companies that actually refine the stuff — took bigger and bigger bets on rising oil prices, influenced in part by fears that the rapid conquests of the extremist Islamic State might disrupt Iraqi oil production the belief that Saudi Arabia would cut output to prop up prices, and expectations that demand was recovering. The size of the stakes taken by these financial players peaked in mid-June.

But in the past three months, the world began to look different. The Islamic State didn’t seem to pose a threat to Iraq’s oil supplies in the south. Libya, despite continuing strife, managed to restore its oil production to between 700,000 to 900,000 barrels a day. U.S. shale oil wells continued to boost U.S. oil output. The International Energy Agency lowered its forecasts for world demand, especially in Europe and emerging markets, bringing its revisions down by an amount roughly equal to Libya’s production. And then Saudi Arabia said it would not unilaterally trim its oil output while other members of the Organization of the Petroleum Exporting Countries kept their taps wide open. The kingdom actually discounted prices for some Asian customers to hang onto its market share.

So prices tumbled more than 20 percent. Many investors in oil futures have bailed out, while others switched their bets. Now the short positions — those that will pay off if prices fall — exceed the long positions — those that pay off if prices rise, according to figures compiled by the Commodity Futures Trading Commission.

And investors are asking: How low can oil prices go?Analysts are saying that we have reached the end of a 10-year “super-cycle” for commodities — a period when a ravenous China was gobbling up almost every commodity on the market. But now China is growing more slowly and a host of new mines and fields have been developed, resulting in overcapacity in many areas.

“I would say that the realization that the commodity supercycle is over has been an important contributor to the sell-off,” Yardeni said in an interview. “It brought home that maybe there was a bubble in that area.” And now it’s bursting. “Too much capacity was expanded to meet the demands of a booming global economy led by China over the next few decades,” he wrote to clients in an e-mail.

Lower oil prices wreaked havoc in the stock market, wiping out 25 percent to 30 percent of the value of big domestic oil companies that had struck it rich in shale oil reservoirs in Texas and North Dakota. That could lead to less exploration, and hurt oil service firms too.

But while lower oil prices hurt the industry, and could slow the pace of rising oil production, there are offsetting benefits for the overall economy. In fact they move money from one set of pockets — the oil companies — to another: consumers. At the September seasonally adjusted pace, retail sales of gasoline would total $535 billion a year, according to Yardeni. So a 30 percent drop in crude prices would pump $161 billion into the hands of Americans over the course of a year.

“It’s almost like a tax cut for consumers,” says Stuart Freeman, chief equity strategist for Wells Fargo Advisors.

But on Wednesday, stock prices of the usual beneficiaries of lower oil prices still fell. Airlines, which save money on jet fuel, were rocked by anxiety that new Ebola cases might frighten people away from the tight confines of air travel. Railroads, which save money on diesel fuel, also carry more than a million barrels a day of petroleum and investors worried that some of that production could be curtailed.

While there have been many sound reasons for the stock market to have dropped this week, there are the other reasons probably foreign to the ears of ordinary investors: The bull/bear ratio, the “death cross” price patterns, moving averages, and resistance points.

These are the topics on the minds of the technicians, the traders who drive much of the buying and selling in the stock market. Judging from the volume of shares that have been exchanged this week, these traders have been out in force. Using technical tools that help them make big moves quickly, these traders can speed up drops in stock prices.

The indicators they examine can be obscure. The “death cross,” for example, occurs when the average price of a stock over 50 days falls below the average price over 200 days, suggesting further declines. The bull/bear ratio refers to the ratio of people who believe stock prices are on the way up to those who believe they are about to head down. Too much optimism can be a bad thing; the only thing to fear is an absence of fear. The bull to bear ratio topped 3.0 during 27 of the 41 weeks since the beginning of the year, according to Yardeni, but fell to 2.18 this week, with the percentage of bulls down to 37.8 percent, the lowest since the week of Sept. 10, 2013.

But Yardeni notes that we should not read too much into these equations. “There’s no particular reason to believe that this is all being driven by algorithms designed by some mad computer scientists working for a hedge fund. The news has been bearish and the market’s gone down. It would have gone down with or without hedge funds and computer programs.”

No surprise

A lot of people have been anticipating a stock market downturn for months, if not years. Nobel Prize winner Robert Shiller, an economics professor at Yale University, has devised an index that measures stock values by comparing prices to earnings averaged over the past ten years. Even at the end of Friday, Shiller’s index stood at 24.7, about 49 percent higher than the historical mean. It exceeded this level in 1929, and again for most of the period from the 1996 technology boom through the bursting of the housing bubble in 2008.

Analysts point to other evidence of a bubble in various markets: the sale of the Waldorf Astoria for $2 billion to a Chinese firm (founded in part by a grandchild of the late Chinese leader Deng Xiaoping), the enormous initial public offering for Alibaba and other technology firms, the merger wave, and the towering level of share buybacks, which have increased per-share earnings by reducing the number of shares as opposed to increasing the output, creating jobs, improving productivity or boosting the value of companies. Buybacks by companies in the S&P 500 have totaled $2.0 trillion from the first quarter of 2009 through the second quarter of 2014, according to figures compiled by Yardeni Research.

“It really had been coming on for quite some time,” said Schwab’s Jones. “It all just finally hit.” She also pointed to the widening gap in interest yields between junk bonds and Treasuries. “That’s usually a sign of stress,” she said. “It indicates that people are less willing to buy riskier credits.”

There have been other warning signals. For the past couple of years, many money managers have been warning that stock prices were overblown. Some of those managers have watched their funds trail broad market indicators while prices were rising. The managers of the Fidelity Low Price Stock fund recently told their investors that “the fund was hurt by its higher-than-average cash position. We began increasing our cash allocation amid the sizable run-up in the Russell 2000 Index last year, deeming many stock valuations too high.”

But many investors have kept money in the market, convinced that the underlying U.S. economy is strong. Most remained unfazed
by the tumultuous midweek ride. They stuck with their investment plans.

Harold Elish, New York-based managing director for wealth management at UBS, said that he received the “usual” number of calls from individual clients he advises, noting that “about two-thirds of them were interested in whether there were bargains to buy.”

“In the past 15 years, and particularly as a result of 2008, clients have lived through extraordinarily difficult stock markets,” Elish said. “Anyone who still owns stock understands that prices can fluctuate. A certain amount of volatility is a risk factor you have to accept or you shouldn’t be in the markets.”

After two years of relative calm in the stock markets, some investment strategists say bigger swings are coming back. The S&P 500 stock index closed up or down by more than 1 percent at least eight times so far this month, according to S&P Dow Jones Indices. That’s more than the five such days seen in July, August and September combined. (As recently as last month, the S&P 500 and the Dow Jones Industrial Average were reaching new highs.)

Historical trends show that markets go through significant pullbacks every five to six years, points out Jeff Cutter, adviser and owner of Cutter Financial Group, which has about $80 million in assets under management. Indeed, the last bear market for the S&P 500 index ended five years ago, and the one before that came after five years of calm markets between 2002 and 2007. The majority of those pullbacks also start between the months of June and October, Cutter says.

Investors should pay attention to the parts of their portfolios that are likely to see wider swings and scale back in those areas now, says Bob Landry, a portfolio manager at USAA Investments. People worried about volatility can scale back exposure to sectors that may not do as well when global growth is slow, like energy, industrials and tech, he says. Landry isn’t holding more cash than usual but if stocks pull back more, he is planning to use the cash he does have on hand to buy stocks that have hit more favorable prices.

Even some of the investors bracing for more volatility say the stable economic outlook at home, compared to the slowdown in Europe and China, will help markets recover. Ashvin B. Chhabra, chief investment officer, Merrill Lynch Wealth Management said that as the market gyrated Wednesday, he was proactive about reaching out to the financial advisers working under him to make sure they were all sending the same message to clients: don’t panic. “We’re not trying to predict the market,” he says, “but we think the fundamentals of the U.S.economy are very strong.”

In the near-term, future market performance may ride on at least one of those fundamentals: corporate earnings. Steady earnings growth has carried the markets this far, even if gains may have been boosted partially by the Fed, says Bernie Williams, chief investment officer for Investment Solutions at USAA Investments.

With many companies still waiting to report this quarter, investors will have plenty of news to trade on day-to-day, which could add to daily volatility, Williams says. A strong earnings season may calm nervous investors. But if companies fall short, the disappointment could lay the groundwork for steeper losses. “In the end, stocks follow earnings,” Williams says.

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