Slowdown raises risk of a sell-off

History isn't supposed to repeat, but investors this year may have the feeling that they've been here before.

U.S. and most foreign stock markets are off to a strong start, the same as in 2006.


And Wall Street's primary obsession remains whether the Federal Reserve is finished tightening credit.

When Fed Chairman Ben S. Bernanke testified before Congress last week, much of his commentary was right in line with the economic "soft landing" forecast that underlies the bullish case for stocks.


"The U.S. economy appears to be making a transition from the rapid rate of expansion experienced over the preceding several years to a more sustainable, average pace of growth," the Fed chief told senators.

Getting the message

Investors got the message: If the economy slows, and inflation stays tame, the Fed is done raising rates.

The stock market responded with the rare occurrence of simultaneous record highs for the Dow Jones industrial, transportation and utility share indexes.

Since 1925, that hat trick has occurred just 20 times. And for the most part, the event has heralded more gains for stocks.

If that track record fails to hold up this time, however, the blame may not be hard to assign.

One threat is the direct fallout from the economic slowdown that Bernanke expects to persist. The housing market is ground zero for these concerns, as home prices continue to decline in many regions.

Some homeowners who received mortgages even though they were high credit risks now are finding that they really couldn't afford to buy after all. That is translating into rising defaults on so-called subprime loans.


The subprime loan woes are rippling into the bond market, because many of those loans were packaged and sold to yield-hungry investors via mortgage-backed bonds.

That feeds into worries about the indirect fallout from a slower economy: What are the odds of a kind of nuclear chain reaction in markets if hedge funds and other big-money players rush to unwind the aggressive bets many of them have made on stocks, bonds and other assets?

One brokerage report making the rounds in London in recent weeks raised the specter of global markets as Krakatoa, a reference to the devastating Indonesian volcano explosion of 1883 that was felt worldwide.

Hedge funds and other high rollers have made liberal use of borrowed money to make their bets. Leverage magnifies gains when markets are going your way. But when a bet goes sour, leverage magnifies your losses.

The risk of a cascade of selling by leveraged investors desperate to close out their positions is ever present in markets. The question is whether it's a far greater risk today than Wall Street overall wants to believe.

Test might loom


A big test may loom: Japan, with its rock-bottom interest rates, has been a popular place for global speculators to borrow and use the loan proceeds to buy investments elsewhere.

If Japanese interest rates are heading higher, those yen loans may no longer work so well, spurring speculators to close them out and sell whatever it was they bought - U.S. subprime mortgage bonds, for instance.

Fear of a Japan-induced selling wave ticked up last week, after news that Japan's economy grew at a brisk 4.8 percent annualized rate last quarter. That fueled talk that the Bank of Japan could raise its key interest rate from 0.25 percent to 0.50 percent when policymakers meet this week.

Even at 0.50 percent, Japan's rate would be a pittance. But in markets, it's often the trend that matters. The Bank of Japan raised the rate from zero in July. Another increase could cement the idea of an upward trend.

And that, in turn, could compel some speculators to terminate their bets.

A surge in the value of the yen last week reflected the sudden turn in sentiment on Japanese rates. And as the yen strengthens it makes life worse for speculators by raising the cost of paying off yen-denominated loans.


Paying no notice

But if these are the early rumblings of Krakatoa, it's clear that global stock markets aren't paying much attention. The Dow indexes weren't the only ones hitting record highs last week.

It may be that, for many investors, the market meltdown scenarios either are too far-fetched, or are so dire that there wouldn't be any point in trying to prepare for them.

To Wall Street, what isn't far-fetched at the moment is that the Fed could be engineering the same transition it achieved in the mid-'80s and again in the mid-'90s: a soft landing that stretches out the expansion and, thus, stocks' bull market.

History repeating? Bernanke says it's quite possible, and right now that's pushing aside a lot of things investors might otherwise be nervous about.

Tom Petruno writes for the Los Angeles Times.